Why China Stocks Trade So Cheap (And Which Stocks Should Fly)

by: James Altucher

I'm at the Rodman and Renshaw conference. I didn't feel like actually registering for the conference so I'm just pretending to be registered and I'm wandering around in the hallway right outside talking to random CEOs among the more than 600 CEOs of public smallcap companies here presenting their wares.

About half of the companies here are from China. Every company seems amazing: from "tiny" cities in China that have more than 10mm people in them (it seems like every city in China is bigger than Manhattan), with 20% growth or more, tons of cash flow, etc. But they all seem to trade for 5 to 10 times earnings or even less while their American counterparts trade for 15 times earnings or more.

So why do they trade so cheap and how can we overcome these obstacles to find the winners that will be the next BIDUs?

A) Nobody seems to trust the accounting. There have been scandals but the regulators have been cracking down lately. That said, investors are nervous and not quite trusting any of the companies yet except for the "name" stocks like a BIDU, SOHU, etc. One way to check the box on this and get more comfort is to at least see if they have one of the Big 4 accounting firms doing their audits.
B) There's no M&A activity. In the US, if a company trades for 7 times earnings, eventually investors will suspect it's a takeover target and start buying the shares. There does not seem to be any takeover or private equity activity on China companies public here in the US. I can't think of any examples at least. So companies are not getting bid up by investors looking for takeover targets.
C) No dividends. Many of these companies are still young and growing along with the Chinese economy. It's not a mature economy like the US so it's not producing mature companies yet. Hence, I don't know of any of these growing companies giving out a big dividend. So that excludes a lot of investors. If they never dividend the cash, then what's the point?
D) Regulations. Although China is probably less regulation-prone these days than the US, there is the sense among investors that the Chinese government can do ANYTHING at ANYTIME to wipe out whole industries. If you assume a small discount for each of the above items then that could account for the fact that good, growing Chinese companies trade for just 5-10x earnings. But this won't last forever. Just like BIDU broke from the pack and traded for 200x earnings, other companies will reach stability, gain investor trust through consistent growing earnings and good communications with investors and eventually achieve multiples that exhibit growth. Additionally, sometime in the next year I suspect we will see a pickup in M&A activity, dividends, share buybacks, etc and the Chinese government will make it more clear that they will not get in the way of companies listed here. Along with stocks I've mentioned in prior articles, I'm bullish on:

Zhongpin (NASDAQ:HOGS): trades for 7x forward earnings and I've recommended it in the past (when Swine Flu was the latest scare).

Wonder Auto (OTCPK:WATG): trades for 9x forward earnings despite 37% growth in revenues. They supply the auto industry. If you don't think the auto industry is booming in China, check out the 100 mile traffic jam that keeps happening there.

Fushi Copperweld (NASDAQ:FSIN): trades for 6x forward earnings and has an extra $80mm cash in the bank (more than 27% of the market cap). Makes copper parts for electric cars. With the auto business booming and pollution a problem, China is helping finance the entire electric car industry.

Sina (NASDAQ:SINA): trades for 6x earnings and has an extra $800mm in the bank. SINA is like twitter, gaming, and portals all combined into one.

Rino (OTC:RINO): trades for 5x earnings. Does wastewater treatment in China. 1 of every 2 hospital beds in China is occupied because of a dirty water-related illness. This is a huge industry in China. RINO experienced 100% earnings growth last year.

China stocks will have their day in the sun and these stocks will reach multiples of 20. As one 70 yearish investor told me at the conference. One of these days I'll look back and say to myself, "I wish I had been a little more brave back then.." I hope he's right.

Disclosure: No positions