3 Stocks That Will Lead the Next China Rally

by Ivan Martchev | April 15, 2011 12:01 am

In the past six months, we’ve seen four rate hikes by the People’s Bank of China (PBOC), and rather than continuing to decline as everyone had expected, Chinese A-Share stocks are now rallying. What gives?

Well, I think the stock market feels that the end of the PBOC rate hikes is near. The Chinese economy had been growing at an unsustainable pace — an alarming 11.9% in the first quarter of 2010 — so the monetary tightening that came in the form of short-term rate hikes, reserve requirement increases, and lending quota cuts was to be expected.

This naturally caused mainland Chinese equity indexes to underperform, as the tightening applies extra pressure on financial stocks and property developers. Yet even with those actions, there is still no evidence of the crash in the Chinese commercial and residential property markets that had been feared by bears in the camp of Jim Chanos and the like.

There are certainly issues that the Chinese authorities would like to address — such as the rapid growth of shadow banking lending that is outside the control of the PBOC. This type of lending is facilitated by Chinese trust companies that repackage loans to be sold as wealth management products to wealthy Chinese customers. Deposit rates in China are still negative in real terms, so the appeal of such products with higher yields is understandable.

As best can be estimated, such trust companies now control about 2.5 trillion yuan of the total 48 trillion yuan loan book of the Chinese financial system. While this is an issue, it also appears that China is far from the excesses that we saw in the United States in 2007, a time when the shadow banking securitization industry had become larger than the banks themselves when measured by the amount of credit provided.

So I have high hopes we will be able to avoid the rampant securitization of otherwise questionable loans like the kind we had in the United States in 2006 and 2007, especially since the Chinese authorities are very mindful of the likely results of a busted credit bubble with the global financial crisis still fresh in the minds of world leaders.

How to Play the Monetary Tightening Finale

Financials and real estate plays sound controversial, but those are exactly the types of stocks that I expect to lead in the coming rally as the PBOC gets out of the way. This is because their business had been constrained by the central bank, yet the Chinese economy continued to grow at a remarkable pace. The earnings power of financials and real estate plays should feel the biggest catapult effect toward the end of 2011.

China Stock #1 China Life Insurance (LFC)

The largest Chinese financial stock traded in the U.S. market is China Life Insurance Company (NYSE: LFC[1]). The company is a multi-faceted financial. It has three distinct subsidiaries involved in asset management, life insurance and property insurance businesses.

LFC is not too far off its 52-week low of about $53 due to the flattish profit picture in 2010, when net income rose 2.3% to 33.6 billion yuan. The shares trade at 16 times forward earnings and 3.4 times book value, which is a good valuation metric for a financial with a leading position in a market with 1.3 billion potential customers.

China Stock #2 China Real Estate Information Corp. (CRIC)

On the real estate side of things, China Real Estate Information Corporation (NASDAQ: CRIC[2]) is a leading provider of real estate information, consulting and online services in China. But the fast-growing company picked a terrible time to list in the U.S. market in late 2009 — with PBOC tightening right around the corner. Still, the operational performance certainly shows the potential of this business.

Total revenues for 2010 increased 82% year-over-year to $174.2 million, from $95.7 million for the full year of 2009. And revenues last year also included $66.9 million, attributable to online services, while full-year 2009 revenues included $13.8 million in fourth-quarter revenues from online services. Revenues from the core real estate information and consulting services were $107.3 million, an increase of 31% compared to the full-year 2009.

The shares were very expensive when they came to market in 2009, which is why we saw a gradual decline despite the good numbers. They are not cheap now, trading at seven times sales and 46 times earnings, but they are certainly much cheaper than other plays capitalizing on China’s rapidly developing online commerce sector. I think that as the market feels the end of the PBOC tightening, CRIC shares will respond favorably.

China Stock #3 E-House (EJ)

If CRIC is posting rapid growth at too high a multiple for your tastes, consider its parent, E-House China Holdings Limited (NYSE: EJ[3]), which is also publicly traded in the United States. This is a real estate services company dealing in primary agency services, secondary brokerage, information and consulting, advertising, online services and investment fund management. So, if there is an end to the monetary tightening from the PBOC, EJ will inevitably feel it.

E-House sold 11.9 million square meters of new properties for the full-year 2010, an increase of 8% from 2009. Total value of new properties sold was $15.8 billion, a 22% pop from 2009. And total revenues were $356.5 million for an increase of 19% from 2009, including $66.8 million contributed by CRIC’s online activities.

The company used the jitters in 2010 to consolidate its leading position and build relationships with top developers. At 11 times forward earnings and 1.1 times book, I think plenty of pessimism is already priced into the shares.

Endnotes:
  1. LFC: http://studio-5.financialcontent.com/investplace/quote?Symbol=LFC
  2. CRIC: http://studio-5.financialcontent.com/investplace/quote?Symbol=CRIC
  3. EJ: http://studio-5.financialcontent.com/investplace/quote?Symbol=EJ

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