What to Buy in China

Includes: DIA, SORL, SPY
by: Joseph Levy

Click to enlargeChina is an area with tremendous potential for equity investors. As with all great opportunities, these are accompanied by increased risk, which can result in large investment losses. In reviewing the financials of various Chinese companies, I see far more accounting irregularities as compared to US entities. The question in my mind is whether to buy individual stocks or mutual funds that focus on investing in the Asia Pacific (excluding Japan) region. I tend to favor the latter approach, but one company that we like and have invested in is SORL Auto Parts, Inc. (NASDAQ:SORL).

SORL is principally engaged in the manufacture and distribution of automotive air brake systems, air controlling systems and other related components for different types of commercial vehicles, such as trucks, and buses. They have grown their sales from $33.1 million in calendar year 2003 to $138.6 million in 12 months ended March 31, 2010. The Company has been profitable in each year from 2003, when net income from continuing operations totaled $3.3 million and has increased sequentially thereafter, reaching $15.0 million or $0.81 per share based on 18.9 million diluted shares outstanding in the 12 months ended March 31, 2010. Based on the May 14, 2009, closing price of $9.59 and approximately 18.9 million shares outstanding, SORL has a market cap just over $180 million.

The Company weathered the recent recession well by overcoming a very weak Q-1 2009 (sales of $20.2 million, net income of $945,000 and EPS of $0.05) and ended the year 2009 with higher net income ($12.8 million versus $12.4 million) and EPS ($0.70 versus $0.68) than the year 2008. Q-1 2010 sales rose to $34.1 million, resulting in net income of $3.2 million and EPS of $0.17, which were well ahead of the depressed numbers for Q-1 2009. Management has forecast Q-2 2010 sales of $47 million and net income of approximately $4.3 million.

To reflect the better than expected Q-1 2010 results and the higher guidance provided by management, revenues were estimated to be $164 million for the year 2010 and $198 million for 2011and EPS estimates were $0.80 for the year 2010 and $0.97 for 2011. Besides increasing sales in recent years, SORL has been successful in improving profit margins with net income as a percent of sales increasing from 7.7% in 2005, to 9.1% in 2006, 9.2% in 2007, 9.6% in 2008, 10.2% in 2009 and 10.8% in the 12 months ended March 31, 2010.

SORL is looking to expand into a global distribution network beyond the Asia-Pacific region. On November 11, 2009, the Company entered into a joint venture agreement with MGR, a Hong Kong-based global auto parts distribution specialist firm. On April 7, 2010, they announced a strategic supply agreement with Shandong KAMA Automotive manufacturing Co., Ltd., which has over 300 sales and service stations in China and also exports its products to over 40 foreign countries. SORL was also designated as a key supplier by the Shandong Wuzheng Group, where the Company expects to double their 2009 sales in 2010. The above initiatives should bode well for SORL growing the Company in the future.

The Company is in excellent financial condition as of March 31, 2010, as reflected by the comparison of certain balance sheet information with the amounts on December 31, 2007 as shown below:

($ Amounts in Thousands)
Mar. 31, 2010 Dec. 31, 2007
Cash & Equivalents $18,621 $4,340
Accounts Receivable 40,953 30,586
Inventory 20,795 8,220
All Other Assets 65,609 50,828
Total Assets $145,978 $93,974
Total Liabilities $17,529 $21,477
Stockholders Equity 128,449 72,497
Total Liabilities & Equity $145,978 $93,974
Click to enlarge

Using the closing price of $9.59 on May 14, 2010, SORL has a market cap of approximately $181 million, which is 1.3 times annual sales, and a PE multiple of 11.8 X EPS in the 12 months ended March 31, 2010, as shown below:

$ Amounts in Thousands
Except Per Share Data
12 Months Ended March 31
2010 2009
Sales $138,639 $118,657
Operating Income 18,187 12,013
Net Income 14,968 9,785
EPS $0.81 $0.54
Click to enlarge
Stock Price May 14, 2010 $9.59
PE Ratio 11.8X
Diluted Shares O/S 18,872
Market Cap $180,979
Market Cap / Sales 1.3X
Net Book Value $6.81
Click to enlarge

I believe SORL’s shares have good potential for appreciation in the future based upon their history of successfully operating the business in recent years and the projected above average growth in China, as well as internationally, in emerging markets.

As I see it, China and other emerging markets are regions where any investor in equities should have at least a limited exposure. In general, I believe the best way to achieve this is by investing in mutual funds that focus on these regions. For China and Asia the best known name in the industry is Matthews, which has a number of funds that have performed very well over the years. Like the rest of the equity markets, Asia Pacific markets were hit very hard during the down turn from October 2007 to March 2009, but overall since 2006 have outperformed the US equities markets. Below is data about the annual total returns of certain mutual funds operating primarily in the Asia Pacific (mostly excluding Japan) region, which includes six Matthews mutual funds. A pension fund that I manage is currently invested in two of these Asia Pacific funds (MACSX and MCHFX) and also in the Matthews India Fund, MINDX (not shown below).

Annual Total Return (%) History

YTD Year Ended December 31

Symbol 05-14-10 2009 2008 2007 2006 Name of Mutual Fund

MACSX 2.5% 41.4% (32.1)% 21.5% 23.4% Matthews Asian Growth & Income

MAPIX 6.2 47.6 (26.0) 18.1 Matthews Asia Dividend

MAPTX (0.3) 75.4 (46.1) 33.7 27.2 Matthews Asian Tiger

MATFX 4.3 70.3 (51.9) 23.7 21.3 Matthews Asia Science & Tech.

MCHFX (3.7) 78.3 (49.0) 70.1 64.8 Matthews China

MPACX 2.9 44.8 (37.4) 11.9 17.4 Matthews Asia Pacific

DFRSX (1.3) 97.0 (57.0) 40.1 39.3 DFA Asia Pacific Small Company

FPBFX 7.9 59.3 (55.8) 25.2 16.2 Fidelity Pacific Basin

IASMX (3.7) 86.1 (57.4) 46.0 36.1 Guinness Atkinson Asia Focus

ICHKX (2.9) 92.8 (54.5) 65.1 39.6 Guinness Atkinson China & HoKong

PRASX 1.2 102.8 (61.0) 66.4 36.1 T. Rowe Price New Asia

Average 1.2% 72.3% (48.0)% 38.3% 32.1%

The average return for the eleven Asia Pacific funds listed above was impressive in the years 2006 through 2009 despite the big decline in equity markets from October 2007 to March 2009. If $10,000 had been invested equally in the funds shown above on January 1, 2006, this would have grown to approximately $16,400 by December 31, 2009. Not too shabby considering this included one of the worst down periods (from October 2007 to March 2009) in the equities markets. By contrast equal investments made into a composite index of the Russell 2000, Dow Jones Industrials, S&P 500 and NASDAQ, plus assuming an additional return of 2% a year for dividends paid out, would have led to a $10,000 investment made on January 1, 2006, growing to approximately $10,400 by December 31, 2009. This comparison points out why it makes sense to have at least some limited exposure to equities in the Asia Pacific (excluding Japan) region and other emerging markets for the long-term.

Disclosure: Author long SORL, MACSX, MCHFX and MINDX