Chinese Small Caps Affected by Strong Yuan

Includes: GURC, NEWN, WEMU
by: China OTC Player

It is a matter of time before the Chinese Yuan is allowed to appreciate against the dollar. While that is not likely to be tomorrow, it could possibly come sooner than expected. With that in mind, I want to highlight some companies that will be affected by a change to the currency peg.

The first thing to note is that all U.S.-listed Chinese securities will benefit. As investors, we're using our U.S. currency to buy into a stream of future cash flow denominated in Renminbi. If Renminbi strengthens, this stream of cash flow will clearly be more valuable. As such, buying Chinese stocks (small caps or otherwise) is also a bet that the Chinese currency will go up. So this is a good thing.

But the effect is not going to be the same for all Chinese companies. There is one category of stocks that will come out ahead, and those are the ones who source for their raw materials in the international market and sell their products domestically.

A prime example of this is Guanwei Recycling Corp (OTC:GURC). Guanwei sources waste plastic materials from countries such as Germany, Spain, and Netherlands, and then imports them into China. There, these waste products are recycled into low density polyethylene (LDPE) and sold to domestic Chinese customers.

If Renminbi rose, the cost of goods sold for GURC should go down, and given the company's position as a low-cost manufacturer, their margins vis-a-vis their customers should at least be maintained. Guanwei announced last week that it has doubled its supplier pool and increased its customers by "approximately 50%". This is clearly a company on the rise and I've been looking to start a position at the right level.

Then there are the companies, the more traditional Chinese manufacturers/exporters, that source their raw materials domestically and earn their revenues in the international markets. These companies will become less competitive, and could suffer significant setbacks.

The first is Worldwide Energy and Manufacturing (OTCPK:WEMU), a contract manufacturer that provides services to more than a hundred companies here in the U.S. To fulfill its customer’s orders, WEMU engages subcontractors located mostly around the Shanghai area. As middleman, the company is especially vulnerable. With a rising Yuan, U.S. companies may be driven to seek out manufacturers directly, leaving Worldwide out in the cold, even if its value-add of having an interceding engineering staff has been working so far. I think this is the reason the company has been on a quest recently to buy over factories -- it is slowly turning into a direct manufacturer.

Then there is New Energy Systems Group (OTC:NEWN), which makes lithium ion batteries and backup systems used in electronic goods and sold all over the world. While the domestic market has traditionally been where the company has derived the bulk of its revenues, there has been a push to sell its products overseas. For example, in January 2010, the company signed an agreement with a European distributor that should increase its sales by $3 million this year. This is but one distribution agreement, and yet, compare that figure to the company's 2009 Q3 revenues of $7.8 million. NEWN doesn't seem too perturbed by the rising Yuan, but it should.

The bottom line is, some companies will gain while others will face greater hurdles to their core businesses. As long as these companies are able adapt (and there is no reason why they shouldn't given the drive toward greater domestic consumption in China), they will be fine. Made in China for the Chinese, that's the future.

Author's disclosure: None.