China: Be Bullish, but Be Prudent

by James Brumley | November 27, 2012 8:35 am

China: Be Bullish, but Be Prudent

If you’ve been scanning just the headlines lately, odds are good that you’ve soured again on China as an investment opportunity. The buzz is that, as of October, direct investment in the country’s companies — by foreign investors — has fallen in nine months[1] out of the past 10; year-to-date foreign investment in China is off by nearly $92 billion.

As the old saying goes, however, there’s more to the story.

While the cash spigots of new, direct-investment money have been crimped to the tune of 3.4% year-to-date, there’s an undeniable inflow of money being poured into the country’s companies through other means: mutual funds. In September, October and the first half of November, almost $4 billion was handed over to funds[2] that specifically invest in China’s equity opportunities. That in no way offsets the $92 billion that hasn’t been invested in the country for the year so far (compared to last year) as direct investments. Then again, it’s also only been two-and-a-half months. Is more money on the way?

Even if not one more dollar is turned over to China-centric funds, though, the fact that $4 billion has already been handed over raises two key questions:

What Are These Investors Seeing?

To give credit where it’s due, there’s plenty of value here. The average Chinese blue-chip stock is trading at an average trailing P/E of 9.2. That’s about as cheap as any country’s stocks are collectively priced right now, and remarkably cheaper than the S&P 500, which is priced at 12.1 times trailing income.

It’s not like that average is being skewed by only a handful of obscure names, either. China Petroleum & Chemical (NYSE:SNP[3]), one of the country’s biggest names, is trading at a palatable 10.8 times its trailing earnings, and only 7.9 times its forward-looking profits. Internet and wireless technology manufacturer NetEase (NASDAQ:NTES[4]) is valued similarly.

Better still, these Chinese blue chips — likely too big to get away with the accounting shenanigans their small-cap counterparts got away with — have a compelling future. China Petroleum & Chemical is expected to grow its income by 28% next year, while Huaneng Power International (NYSE:HNP[5]) is on pace to expand earnings by 32% in the coming year.

You get the idea: If things are slowing down in China, not every company is feeling that pain. Then throw in the fact that China’s PMI reading for November[6] improved for the first time in 13 months … and maybe the worst really is over.

Should Other Investors Follow Their Lead?

So if $4 billion worth of (presumably) smart money is getting back into the China game against the apparent grain, do these folks know something you don’t?

That’s the $64,000 question. The answer is: It depends.

We’ve seen a few hints of a rebound in China following nearly a year’s worth of tepid results, and enough of its publicly traded companies are doing just fine.

We’ve also seen red flags, like a rising number of non-performing loans, and third-quarter profits that fell 5.8% on a year-over-year basis for China’s biggest and best.

It’s a conundrum, to be sure.

As usually is the case, the truth likely is somewhere in the middle — China is neither in the deep trouble some pundits suggest it is, nor is it the white-hot opportunity other talking heads are implying.

China is, for all intents and purposes, a mixed bag of good companies and bad ones.

It was bound to happen eventually, and in retrospect actually is a lot like the boom/bust cycle for the U.S. stock market between the late 1990s and early 2000s. Most all of China’s publicly traded companies went through a boom cycle between 2006 and 2010 when they could no wrong and were able to raise any amount of money they wanted. The country’s stocks then entered a bust cycle between 2010 and now, when even the good ones were cursed for the sins of fraudulent and weaker names. Now, with the dust settling and the frauds being ferreted out, cautious investors are finally starting to wade in with their eyes wide open.

In other words, the pendulum is starting to swing in a bullish direction again — even if not as quickly as it was swinging just a few years ago.

Bottom Line

Not that the $4 billion that has been put into Chinese stock funds since the beginning of September is an ironclad guarantee, but it’s not an errant allocation — the opportunity is there. The merits of those opportunities just need to be considered on a case-by-case basis, which is something that’s not been done in earnest until now.

Turning that money over to a fund manager isn’t a bad way to go about picking China’s top stocks, though investors willing to do a little legwork might actually be able to find the country’s best picks on their own. Just keep those expectations in check.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

Endnotes:
  1. fallen in nine months: http://www.scmp.com/business/money/markets-investing/article/1086948/foreign-direct-investment-china-drops-further
  2. $4 billion was handed over to funds: http://www.cnbc.com/id/49958784
  3. SNP: http://studio-5.financialcontent.com/investplace/quote?Symbol=SNP
  4. NTES: http://studio-5.financialcontent.com/investplace/quote?Symbol=NTES
  5. HNP: http://studio-5.financialcontent.com/investplace/quote?Symbol=HNP
  6. China’s PMI reading for November: http://online.wsj.com/article/SB10001424127887324352004578133783777308020.html

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