After climbing by over 150% in 2015, China has now corrected by 40% as fears of a bubble came to fruition. The economy is slowing, and people have begun to panic.
The question now is whether or not buying Chinese stocks in 4Q2015 and 2016 is a good time. Let’s discuss!
The Ren Min Bi (RMB) has a managed peg to the USD which currently stands at roughly RMB6.2:$1. The RMB has appreciated by a couple percentage points every year for the past decade and there are no signs of such appreciation abating. You know how I always write that everything is relative in finance? Well, the relativity of a massively depreciating Yen and a continued strengthening RMB has never become so apparent as it is today.
A weak Yen and a strong RMB pose a problem for China because Japan is its largest trading partner in the region at 7% of total exports. The largest export partners for China are the US at roughly 17%, the EU at 16%, and ASEAN at 10%. China has two main goals: 1) to ensure strong domestic economic growth to provide enough jobs for its 1.2 billion population which continuously migrates to urban centers from the countryside, and 2) to be taken seriously by the world. I cannot tell you how important respect is in eastern culture.
As a Communist country with millionaires and billionaires, managing social happiness is priority number one. Although an annual 7.7% GDP sounds wonderful compared to a 2% US GDP growth rate, such high levels of growth are necessary to prevent social unrest. Take what happened at the height of the Occupy Wall Street movement and multiply the anger by 100 to get an idea of the repercussions of a growing unemployed population that lives at home with their parents until marriage.
OLD ATTITUDES TOWARDS THE JAPANESE DIE HARD
When I studied abroad in Beijing for six months in 1997, I discovered an enormous hatred for the Japanese largely due to the horrific crimes of the Nanjing Massacre. What’s worse, Japanese history books have refused to acknowledge such atrocities occurred. It was only until 2005 did then Prime Minister Koizumi apologize to China for its WWII aggressions that killed at least 300,000 Chinese. Unfortunately, Japan was 68 years too late.
The friends I met in 1997 are all in their 30s and 40s now. I’ve kept in touch with a couple of them and their attitudes against the Japanese are still the same. The difference now is that they hold managerial positions whereas back then, we were all powerless students with only hope to contribute. There is a deep seated drive for so many Gen X Chinese to beat their Japanese counterparts in everything they do. I don’t think such hatred will disappear until a new generation grows up. Now imagine the hatred of the Japanese by those Chinese in their 50s and up. Things take time to change.
If Japan is working voodoo economics and benefitting at China’s expense, there is absolutely no way China will stand idle.
CHINA WILL BRING OUT THE CANONS TO INSURE GROWTH
There’s clearly been a slowing of the Chinese economy with the latest 1Q13 GDP reading coming in at 7.7% vs. 8% expected, and the HSBC PMI index coming in at 50 vs. expectations of 52. The stock market has reflected such a slowing with a 10% drop in 2013 so far based on the China ETF, FXI which holds the largest Chinese stocks that have a blended P/E average of around 9.
China down 10% while the US and Japan are up 15% and 20% year to date is embarrassing. The one thing investors should be able to count on is for the Chinese Central Government to more or less deliver on its economic promises because they cannot afford not to. One of the longest running jokes amongst economists who follow China is that China can manufacture any economic figure they want. For example, stated inflation is only around 5%-6% a year. Anybody who lives in China knows that the real rate of inflation for food, housing, and income is well into the double digits. The paradox is somewhat like here in the US, only many times worse.
If the Chinese stock markets begin cratering because investors are too fearful of collapsing home prices, the Chinese government will simply lower reserve requirement ratios for banks, speak to their local government heads to expedite infrastructure spending, and report to the market that everything is alright. Command economies are fantastic for getting things done efficiently. Why do you think there’s been such a difference in the pace of improvement between Communist China and Democratic India? The red tape and corruption in India is stifling to progress!
To ensure over 7.5% annual GDP growth to maintain social stability, China must simply manage fiscal and monetary spending. China has a current-account surplus of over $200 billion with foreign exchange reserves of some $100 billion dollars. These levels as a percentage of GDP have come down over the years, implying a more normalized economy, yet these figures are still enormous to allow for more supportive economic policy if needed.
There are no ridiculous stalemates in China like we have here in the US with Congress. If China wants to get something done, they will.
CHINESE STOCKS I’M BUYING
One of the biggest benefits of rolling over my 401(k) into a IRA is flexibility. With an IRA, I can buy whatever I want, and what I want to buy are Chinese securities at the moment.
My investing style: Aggressive, speculative, mispriced growth, risk-Loving, “no bet, no win” attitude.
Previous stance: Social media bubble will collapse, mentioned in my predictions post for 2012 written in 2011.
Current investor sentiment: Risk-on with fear of a pullback during the summer.
Central bank stance: Dovish, accommodative, willing to do whatever it takes.
Risks: Regulatory, accounting peculiarities, demographics, social unrest from a much sharper economic slowdown than expected, high local government debt, corruption, stocks are in a downtrend despite high GDP growth.
Experience: Lived in China, traveled to China many times, met with management, listened to their conference calls, met with analysts, and understand the internet and social media space.
Goal: Capital appreciation and to consistently beat the S&P 500 index for as long as possible.
* Baidu (BIDU) – Often dubbed “The Google Of China,” Baidu is down roughly 45% in the past two years as competition in search heats up. Unlike Google, Baidu does not have the whole Android operating system. Baidu still commands roughly 80% of the total online PC engine market share, but competition is increasing with the likes of Qihoo who went from 0% to a 12.5% market share in just one year.
Non-gap operating margins fell to 39% in the latest quarterly results, a 7% QoQ decline as the company ramps up expenditure in mobile and software. The stock trades at roughly 17.5X trailing consensus estimates after trading as high as 99X in the past. Its competitors are trading at roughly 25X earnings.
With Baidu having just recently missed its latest quarterly revenue and earnings on 4/25, I’m a buyer because the company is still expected to grow earnings by 40% despite it investing heavily for the future. I like stocks that get punished for investing in future opportunities while holding lots of cash. Mobile is a huge and necessary expenditure, but at the cost of lower margins. I look at the growing percentage of traffic coming to Financial Samurai as proof of the necessary shift. Target: $110. Current price: $85. Downside: $70.
* Sina (SINA) – Sina is down roughly 60% from its highs as the euphoria over its Weibo platform (Chinese Twitter) dissipated. Sina is having a tough time monetizing Weibo just like Twitter is having a tough time monetizing its platform. That said, Alibaba (Chinese eBay/Amazon cross) announced a 18% stake for $586 million in Weibo, valuing the entire platform at $3.3 billion compared to Sina’s current market cap of around $3.7 billion. Alibaba has some 500 million users and such a tie-up could do wonders into monetizing Sina’s 45 million or so active daily users.
Sina’s main business is through advertising and is very much like Yahoo. With Twitter’s current valuations rumored at $8-10 billion (albeit with a much higher daily active user base), and talks of Twitter potentially going public end of this year or in 2014, I think the market will focus on Twitter-like companies like SINA. Target: $70. Current price: $55. Downside: $40.
* RenRen (RENN) – RenRen is very similar to Facebook and requires real name registered users unlike its competitors. The stock IPOed at $18 in May 2011 to much fanfare ahead of Facebook’s own IPO which turned out to be a dud. RenRen has since lost over 80% of its value as it continues to lose money every quarter. It’s getting hammered in gaming, video, and by other social networks like Tencent. We all know what happened to Friendster, MySpace, and Digg. If you aren’t first, you’re last in the social media space.
The good thing about RenRen is that it has $2.40 in cash per share. In other words, out of its estimated $1.08 billion market cap, $850 of that is in cash. The problem is the company used to have over $1 billion in cash after the IPO as it burns money to figure out how to finally make money. RenRen is my most speculative punt stock given the market cap and lack of earnings. It’s either going start making money after its two years of investments and acquisitions, or do a management leveraged buyout (MLBO) if it trades below cash value in my opinion. Target: $4. Current price: $2.75. Downside: $2.30.
* iShares FTSE China 25 Index Fund (FXI) – As mentioned previously, FXI is an ETF that tracks China’s largest, and most liquid names. FXI is a low cost way and less volatile way to get broad market exposure to the economy. Even though we are heading into a historically slow period for the equity markets between May-August, it’s clearly “RISK-ON” again for US investors at least. As a US investor, I’m looking for laggards. What happens in developed US, will be repeated in developing countries like China if regulation doesn’t get too much in the way.
I expect the Chinese economy to re-accelerate in the second half of the year as output catches up with domestic demand. Monetary policy will continue to be very accommodative and any type of real estate bubble scenario will be well managed. With China underperforming by a 25% spread vs US equities YTD 2013, buying FXI looks attractive. Target: $45. Current price: $37. Dowside: $32.
X-FACTOR: One thing that could become very beneficial for Chinese securities listed in the United States or anywhere outside of China is the opening up of domestic Chinese investors to overseas markets. Domestic Chinese investors can only invest in a volatile A-Share market, commodities, real estate, and bank deposits. The main reason for such restrictions is due to capital flight. China will slowly ease restrictions if it wants to continue to develop into a legitimate capital market and such a flood of Chinese money could find its way into Chinese ADRs listed here in the US or many of the H-share names listed in Hong Kong.
INVEST IN WHAT YOU KNOW
In a “risk-on” environment, investors will naturally search for laggards. The collapse of the internet/social media space over the past couple years has come true and current levels look attractive. I’ve done all the due diligence I can as a retail investor. Furthermore, I understand the fundamentals of the internet and social media business as someone who intimately operates in the space. Even with writing this post, there is no guarantee that I will make money in my Chinese equities positions. This is the beauty of the markets!
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About the Author: Sam began investing his own money ever since he opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $175,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
Updated for 2016 and beyond.