In my recent article “3 Chinese Stocks That Should Beat the Rest,” I mentioned that the iShares MSCI China ETF (MCHI) is having a miserable time in 2013, down 9% through June 5 compared to a 13% gain for the S&P 500. That article highlighted some potential winners — but I think as long as China maintains its status quo, plenty of Chinese stocks are bound to fall over the next 12 months.
While it’s tempting to seek out stocks performing badly in the hope investors will continue to bail, I think the wiser course of action is to choose three that have overachieved (relative to the index) so far in 2013 that appear ready for a correction. I’m not necessarily saying they’re bad companies, but if you’re sitting on unrealized gains on any of these three stocks, you might want to consider taking profits:
Ctrip (CTRP), China’s biggest online travel company, hit a 52-week high of $33.02 in the final 30 minutes of last Thursday’s trading. It has improved 45% year-to-date, and 76% in the past 12 months.
Historically, though, this is a stock that has underperformed both the S&P 500 and its lodging industry peers. This is only the second time in five years where it’s actually beating the index, so something must be driving the rebound.
Citigroup’s upgrade from “sell” to “neutral” in mid-May seems to have helped Ctrip’s cause — since the upgrade, the stock is up 7.3% through 14 days of trading. A half-percent per day isn’t too shabby, but it had already booked big gains before that. The really big gain came after announcing strong earnings after the close May 8; the stock jumped 26% the next day on seven times the average daily volume. Citigroup analyst Muzhi Li suggested Ctrip was experiencing a secular growth trend, which is a fancy way of saying it’s growing despite a slowing Chinese economy.
But before investors jump on the bandwagon, they should take a closer look at its earnings report to notice the cracks in CTRP’s armor. The top line revenues grew 27% year-over-year to RMB1.2 billion — much higher than the company’s estimate of 20% growth. However, the bottom-line figures leave a lot to be desired. Gross margins declined by 100 basis points to 74%, while operating margins dropped 500 basis points to 14%. And net income attributable to Ctrip shareholders declined 26% in the quarter to RMB153 million.
Morningstar gives CTRP a one-star ranking, which I imagine is because the stock has gone through the roof while having little control over its expenses, which all increased by double digits in the first quarter. In fact, its operating expenses increased 37% in Q1, 37% faster than its revenue. Ctrip will have to grow revenue at a much faster rate if it continues to ignore its expenses. And given its history, I’m not sure that’s possible. Any stumble on revenue growth will bring its stock tumbling back into the low $20s. For this reason, I’d be locking in profits pronto.
The Gilt Groupe is an e-commerce business that runs 200 flash-sales per week featuring top brands like Jimmy Choo. Only six years old, it already has 7 million customers. Vipshop Holdings (VIPS) is trying to replicate that same success in China with mixed results so far. However, its stock certainly has taken flight, up 353% since its IPO in March 2012 and 65% in 2013. VIPS was the best-performing IPO out of 128 issues in 2012, up 154% — definitely a momentum stock.
Everything about its Q1 report is spectacular: Net revenues grew 207%, gross margin increased by 220 basis points to 23.4%, and net income went from a loss of $8.6 million in Q1 2012 to a profit of $5.8 million in Q1 2013. And Vipshop’s revenue guidance for Q2 was 144% growth year-over-year. There’s not much you can say about its numbers except that it didn’t forecast earnings for the second quarter, which leads me to believe management is having a hard time nailing down expenses. It could just be that VIPS is growing so fast it can’t keep up with its financial modeling … or maybe something more sinister is afoot.
Having invested small amounts in two fraudulent public companies (one in China) over the years, I’m acutely aware of the risks involved in betting on fast growing businesses operated in less-regulated parts of the world. Barron’s ran an article in April that questions the authenticity of some of the products sold in Vipshop’s flash sales. The most flagrant example was Coach (COH) bags sold on its site for $234 to $429.
The problem isn’t that the bags were counterfeit, but that they were sold without Coach’s permission. That raises the question: How did VIPS gain possession of the product in the first place? Whatever the true story is, short sellers began to circle the wagon, forcing VIPS to release a statement addressing allegations of impropriety. One of the shorts is none other than Carson Block, the man who brought down Sino-Forest for its fraudulent actions. Although Block doesn’t regard Vipshop as a fraud, he does believe its business model is badly flawed in the long term.
I personally doubted Herb Greenberg back in 2001 when he was highly skeptical of ACLN, a Belgian-based company (my other loss due to fraud) that shipped cars to Africa. As it turned out, the books were cooked and the stock tanked faster than the Titanic. Now I’m not saying any of the shenanigans that went on back then are happening in this situation, but when a stock rises so quickly and allegations arise, one needs to step back and have an objective re-examination of the facts.
Any future signs of trouble, and VIPS stock will be back in single digits or lower.
China HGS Real Estate
My last pick is more of a hunch than anything else. China HGS Real Estate (HGSH) is an investment company that has no operations itself but whose wholly owned subsidiary, Shaanxi Guangsha Investment and Development Group, operates as a commercial and residential real estate developer in Hanzhong and other Tier 3 and Tier 4 cities in China.
Since its reverse merger in August 2009, China HGS’ revenues and profits have been all over the map. Right now, it appears on an upswing with revenue of $30.4 million in the first six months of fiscal 2013, significantly higher than the $5.4 million in 2012. Same story on the bottom line, where earnings per share in the first six months were 25 cents compared to just 4 cents in the year-ago period. That’s a marked improvement from its entire 2012, which saw revenue drop by $38 million to $18.9 million while diluted earnings per share were 11 cents, 31 cents lower in the same 12-month period in 2011.
No wonder its stock is up 1,270% over the past 52 weeks through June 6. Its performance is like night and day. But what goes up, must come down. The second-best-performing Chinese stock over the past year according to Finviz is Vipshop Holdings, my second sell recommendation, which is up 401% over the last 12 months.
Few stocks can maintain this kind of pace for very long although its current business in development seems very encouraging. Nonetheless, regression to the mean could hold sway in the weeks ahead. If you were lucky enough to buy HGSH below $1 last October I’d definitely recommend cashing in your chips.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.