Should You Buy Into China's Rebound?

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 |  Includes: CAT, CLF, RIO, VALE, WLT
by: BubbleBustInvesting

After heading south for more than two years, China's economic growth is picking up again according to three recent government reports. The first report, published two days ago, shows a 10.4% jump in August industrial production, beating analyst expectations. The second report published by The General Administration And Accounting Office over the weekend showed that China's trade turned the corner last month. Exports rose by 5.1 percent last month, exceeding the 2 percent median analyst estimate. Shipments to Europe - China's largest export market rose. Imports rose by 11 percent.

The third report published by the National Bureau of Statistics two weeks ago showed that The Purchasing Managers Index (PMI) reached a 16-month high of 51.0 in August, up from 50.3 in July, beating market expectations of 50.6 in a Reuters poll - a reading above 50 indicates an expanding economy.

The rebound in Chinese economic growth follows several other economic reports from Brazil, EU, and the US that world economic growth is on the rebound. This means that China's economic rebound may gain steam in the months ahead. Over the long-term, however, China observers are concerned about the growing corporate and local government debt and the safety of its banking system.

"Chinese companies and local governments have borrowed recklessly to build factories, train stations, and bridges to nowhere," wrote Barron's Jonathan R. Laing in a recent cover story China's looming debt crisis. "Miles upon miles of empty apartment buildings rim hundreds of Chinese cities; industries suffer from rampant overcapacity; and largely empty new highways, bridges, shopping malls, railroad stations, and airports more than hint at problems."

That would certainly spell trouble for the country's state-owned banking system, which has financed these projects. "From the beginning of 2009 to the end of June this year, Chinese banks have issued roughly 35 trillion yuan ($5.4 trillion) in new loans, equal to 73 percent of China's GDP in 2011," writes Professor Minxin Pei in the Diplomat. "About two-thirds of these loans were made in 2009 and 2010, as part of Beijing's stimulus package. Unlike deficit-financed stimulus packages in the West, China's colossal stimulus package of 2009 was funded mainly by bank credit (at least 60 percent, to be exact), not government borrowing."

Compounding the problem identified by Professor Pei has been a failure to pursue credit expansion by government-owned banks to government-owned corporations and municipalities; this has not been undertaken in order to enhance the productive capacity of the Chinese economy. Instead, that pursuit has been for the sake of stimulating short-term growth.

Simply put, building bridges that too few people travel, train stations that too few people visit, and buildings that remain vacant, is hardly a way to place an economy on a path to sustainable growth. While such projects create what standard macroeconomic textbooks describe as multiplier effect - multiple rounds of income and spending that boost economic growth while the project lasts - they fail to create the accelerator effect that boosts economic growth once these projects are finished and placed in use.

What should investors do?

The answer depends on the investment style of each individual investor. Value investors may want to stay away from the Chinese market until there is a better visibility on these concerns. Momentum investors may want to trade the sectors that stand to benefit from the short-term rebound in Chinese growth. One of these sectors is ocean transportation, as discussed in a previous piece here. Another trade is to buy into companies that supply materials to Chinese manufacturers like Cliffs Natural Resources (NYSE:CLF), Walter Energy (NYSE:WLT), Rio Tinto (NYSE:RIO), and Vale SA (NYSE:VALE). A third trade is to buy suppliers of construction equipment to China like Caterpillar (NYSE:CAT).

Company

Forward PE

Operating Margin (%%

Quarterly Revenue Growth (%)

Total Cash ($B)

Cliffs Natural

17.23

10.82

-5.8

0.263

Walter Energy

--

9.75

-34.50

0.170

Rio Tinto

9.68

21.84

-3.84

7.77

Vale

8.07

29.34

-7.0

7.09

Caterpillar

12

10.87

-15.80

4.0

Click to enlarge

Cliffs Natural Resources is a large producer of metallurgical coal and iron-ore, the basic materials for making steel, a crucial product in construction. Most notably, Cliffs Natural has a global presence, including Australia, giving the company a geographical advantage to China, vis-a-vis Latin American suppliers--Asia Pacific sales count for 22 percent of the company's sales.

Walter Energy is also a large producer of metallurgical coal with global operations. Its Canadian segment gives the company a geographical advantage as a supplier of China vis-a-vis its competitors.

Caterpillar is the world's largest manufacturer of construction and mining equipment that can certainly benefit from any pick-up in China's construction and mining activity. Last year, Caterpillar acquired Caterpillar Japan Ltd, placing it in a better position to export products to China.

Rio Tinto and Vale SA are two conglomerates with diverse operations that range from iron-ore mining to aluminum, and copper--inputs needed for China's manufacturing sector. I particularly like Vale as the company enjoys hefty profit margins, has plenty of cash, and derives 34 percent of its revenues from China. In addition, Vale stands to benefit from China's plan to ease curbs to allow larger vessels like Vale's Valemax to access its ports--the use of larger ships will allow Vale to narrow the gap with BHP Billiton with mines closer to China.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in VALE over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.