When looking for successful growth stocks, China companies have shown up in my screens quite often in the last few months. One of these success stories is Ctrip.com International (NASDAQ:CTRP). The company operates the largest China based travel portal, offering flight ticketing, hotel reservations, packaged tours and more. During the market crash in the fourth quarter 2008 and the first quarter this year, the stock dropped to a very attractive valuation in the mid to high teens. When considering the company is expected to earn $1.13 this year and the growth prospects are relatively good, this was most definitely a buying opportunity.
Investors who took a chance on the company when the economic picture looked the bleakest were well rewarded with a 140% current gain from the 2009 lows. The company itself has continued to grow revenue and earnings as it captures market share in the difficult consumer environment. However, despite the company (and the stock’s) recent success, the much higher stock price raises concerns of a potential pullback which could cause investors to give up much of the gains from the past few months.
Investors Current Optimistic Attitude
In general, equity markets move ahead of economic trends. This is because stock market participants buy and sell based on future expectations. If I think that the economy will turn higher in 2010, then I will likely begin buying today so that I have my capital in place when that actual turn takes place. The buying pressure usually pushes markets higher before any rebound in the fundamental picture is recorded. This is why many economists are not worried about the continued growth in unemployment and lack of economic growth. They simply believe that this recovery will come in time and that the market has already signaled the change is underway.
But my concern is that the market has fully priced in a recovery and at the end of June we are going to get hard data on just how that recovery has been progressing in the second quarter. Not all of the market buying pressure has been built around second quarter expectations, but there certainly is some hope that Q2 earnings numbers will show a bit of a stall in the economic decline, or even the “green shoots” of growth. If the fundamental reported data fails to deliver this improving picture, we could see investors become disenchanted with their holdings and a quick selloff in the market. Growth stocks with high multiples will be the most vulnerable because they are the companies with the most optimism and therefore the most risk for investor disappointment.
Ctrip’s Potential Disappointment
Ctrip.com fits the “optimistic” category as the stock is currently nearly 40 times the estimates for this year. The high valuation is largely justified by the expected growth as CTRP continues to capture market share and is expected to grow earnings by 28% next year. The company also recently made a stock purchase of Home Inns & Hotels Management Inc. (NASDAQ:HMIN) to increase its stake in the company from 9.52% to 18.25%. The purchase was made at a price of $13.31 (Total value of $50 million) which has quickly produced a 24% unrealized gain. As long as HMIN continues to trade higher, that investment appears to be a wise move. However, HMIN has some of the same dangers as CTRP and could simply leverage the risks already associated with the company.
During the first quarter, Ctrip realized a healthy if not expected growth in both revenue and earnings. However, it appears the company is having to work harder and harder in order to manufacture these attractive numbers. Revenues from hotel bookings account for 43% of total revenues for the company. While the category saw sales increase by 9%, the total increase in volume was 17%. This means that margins on hotel bookings were significantly lower as a weak economy resulted in low pricing power.
Similarly air ticketing revenue (which also accounts for 43% of total revenues) increased by 16%. But in order to outpace the weak pricing, the company actually had to sell 40% more tickets. The obvious question (although I haven’t hear too many people asking it) is what happens when the company is only able to sell 10 to 15% more tickets and the price continues to drop. The result could quickly become lower sales which would set off alarms for institutional and retail investors alike.
Options for Dealing with CTRP
Depending on your situation and risk profile, there are several ways to protect against, or even take advantage of a decline in the stock. Each of these strategies offers different advantages while including certain drawbacks as well. When investing there is rarely ever a “free lunch” (chance for return without some corresponding risk), but many of the financial tools at our disposal can shift those risks and returns to be more favorable for your individual situation. If you would like a second opinion on how YOU should approach investing in this or other investment opportunities, my direct line is always open. So let’s take a look at some of the CTRP options:
- Short Stock - The first and most obvious opportunity if CTRP were to decline would be to short the stock. This means that you profit directly in line with how far CTRP drops. However, if investors continue to be optimistic and the stock climbs, a short position has unlimited potential for losses. For this reason many IRA accounts are not allowed to short stocks.
- Buy Puts - A put contract is simply an options contract which gives you the right but not the obligation to sell the stock at a particular price. You can buy this contract (most IRA’s and qualified accounts allow for this trade) and the contract will increase in value as CTRP declines. The benefit is that if our analysis is wrong, you are only out the amount you paid for the put contract. However, the drawback is that prices on puts include extra premiums for volatility and for the duration (time remaining on the contract). The stock would have to drop significantly or quickly in order to make up for the premium you pay for the put.
- Covered Call - If you own the stock and like the company long-term, but are worried about the potential for a short-term drop, then selling calls against your stock position could be an option. For instance, you could sell the September 45 calls for roughly $4.40 per share which is yours to keep. If the stock drops between now and September, the premium you accepted for these calls will help offset your losses. However, you give up the potential for a strong run as shorting the calls gives you the obligation to sell the stock at $45 if the buyer of the contract so desires. Essentially when you include the $4.40 for the option your selling price would be $49.40 which is better than the current market price.
- Sell Naked Calls - Another aggressive (and potentially dangerous) way to take advantage of the call premium would be to sell the calls naked (meaning without owning the stock). The danger is that for every dollar CTRP trades above $45, you would be on the hook for when and if the owner of the call exercises his right. Until the stock trades above $49.40 you will likely end up with a profit. But above that price your risk is the same as being short the stock.
So you can see that there are several ways to profit from or protect against a decline in this stock. Difficult markets don’t always mean losses for smart investors. I would be interested in hearing your success stories from the last six to 12 months. What moves did you make against conventional wisdom which allowed you to profit while many others were losing? Hopefully we can all learn from the aggregate experiences and put more profits into our investment accounts.
Disclosure: Author does not have a position in CTRP.