Four Undervalued Chinese Stocks: Buy at Your Own Risk

by: Clayton Reeves

So, you want to invest in China, eh? It isn’t all roses and renminbi over there, so you better be sure your risk profile matches the risks associated with investing in a China based ADR. Some of these companies have had issues with financial restatements and borderline fraud while some keep books neater than any you’ll find in the United States Library of Congress.

The reasons for the differences in bookkeeping practices vary. Sometimes these companies grow three and four times over in a matter of months, so they are learning on the go. In other situations, books are cooked in a very familiar and purposeful manner. This is one of the reasons there is such rabid debate amongst investors over the safety of investments in China. Certain things, such as partnerships with reputable audit firms like E&Y or DT can alleviate some of these concerns, but there is always a risk. As a potential investor, always remember that the bluest waters can be infested with sharks just beneath the surface.

One of the reasons I enjoy looking at Chinese ADRs is that China favors their domestic companies. Google (NASDAQ:GOOG) is only one on a long list of global titans that have either complained publicly or withdrawn benignly after encountering obstacles on the mainland.

Chinese President Hu Jintao has rejected this notion, claiming that U.S. companies in fact do have the same opportunity in his country, and that their:

Innovation, production and business operations in China enjoy the same treatment as Chinese enterprises.

He can say that. I’m just not buying it. Chinese companies will always get a better hand dealt, and if you want a piece of the biggest market in the world, now may be the time to pony up. I’ve sifted through the mess of companies that are on everyone’s pump and dump list and tried to assimilate a relatively diverse roll call that can give you exposure to the mainland China boom. The reasons for selecting these stocks vary between plays on value, the Yuan and domestic Chinese growth. Check out an article I wrote on the yuan to get some context in terms of currency. I’ll give a quick explanation for each of these stocks, and then my valuation. I’ll be choosing some of these to dig a little deeper into and provide a more thorough analysis like I do with Baidu (NASDAQ:BIDU).

Before we start, I want to cover something briefly. The debate around these stocks (OTCPK:CCME and UTA in particular) is voracious. Anyone trying to determine if the company engages in shady accounting practices is pegged as a shorter and anyone with a buy recommendation is a pumper. I would love to hear your opinions in the comments section, and I welcome my readers to engage in educated debate.

However, let me be clear when I say that while you can debate all you want, I do not own or currently plan to purchase any of these stocks. I hold them in a virtual portfolio for reviewing, and make these articles for research purposes only. Furthermore, investments should be made after doing thorough research and assessing your risk tolerance. I would argue that the best way to approach financial statement risk in China is diversity. Don’t put all your eggs into one basket. International, Ltd. (ADR) (NASDAQ:CTRP) and Universal Travel Group (UTA) is definitely not an unknown company on the Chinese investing front. Their main sphere is travel. CTRP allows users to reserve hotels online, book flights and purchase packaged tours. Their relative valuation has been climbing, and their PE in the 40s is not reassuring to the value investor.

However, investing in Ctrip is more than a strict value play; it is a play on both the rising middle class Chinese consumer and the appreciation of the Yuan. From a valuation perspective, I still consider CTRP undervalued despite their high price ratios. Some bearish sentiments include put call ratios increasing by just over 12% over the last quarter, according to Kapitall. I think this, combined with their price decrease from their 52 week high in early November, sends rally signals into the air. CTRP has projected 31.36% EPS growth over the next five years and given those assumptions, I have no trouble setting a price floor of $50 and a ceiling of $95 for CTRP. This assumes their financial statements are reliable.

However, some would argue that trends are more bullish for UTA. UTA focuses more on packaged leisure for consumers, while CTRP has exposure to the less lucrative corporate travel industry. Also, one major travel fund invested in UTA recently, but other institutional investors have pulled out. Given the many red flags surrounding UTA (which have been well documented elsewhere), I would only invest if you can afford to withstand the short hits and large fluctuations in price. I think their more recent decisions, including those involving kiosks have been overblown by the shorts. Given their position in a high growth market, I give UTA a price floor of $6 and a ceiling of $20.

Right now, I would invest in both. There are some red flags surrounding UTA, and CTRP may be slightly overvalued. However, there is significant upside to both of these stocks, which I will cover in a later article. They are the leaders in the travel industry and both poised to gain from the appreciation of the Yuan as Chinese travelers find better deals abroad.

China MediaExpress Holdings, Inc. (OTCPK:CCME) Want to get people involved in vociferous debate? Say you’ve invested your entire life savings in CCME and get ready to take some flak. I love reading people's back and forth debates on this stock. I also think commenters spend more time writing comments than contributors spend writing articles about CCME.

Regardless of who is right, CCME is a hotly debated company. Their main source of income is advertisements in buses. This doesn’t sound like a Silicon Valley-type growth company, but stay with me. They primarily deal with brokers, who sell to advertisers based on commission. The company distributes the same content to their screens across their network, and update content on regular intervals. Think about that; CCME basically has a bunch of screens in buses that they send ad content to on a regular basis, that reaches huge groups of people when they have nothing better to do than watch a shiny screen. Not a bad idea, and certainly scalable in the world’s biggest country.

CCME is selling a high volume, low cost product that is digitally replicated and operable from remote locations. They also seem to have a positive approach to dealing with investors, as evident in their new dividend policy and lack of repeatedly dilutive share offerings. In fact, CCME has no need for more cash, and are not currently a takeover target because of this.

Some people point to their audit firm, Deloitte, as being unreliable. Once people start to question the validity of independent audits from Big 4 firms, I think the system starts to break down. Paranoia sets in, and people start talking about conspiracies. Have I been inside buses sporting CCME product? No. But due diligence has been performed on a variety of fronts, and I have come away with the impression that CCME is legitimate. As a result of these assumptions and the level of risk, I give CCME a floor of $32 and a ceiling of $55. They are trading dirt cheap right now, and I think they finally have their ducks in a row. Others to look at include FMCN, who has operated with similar margins and business model since their IPO in 2006, without much controversy. The model works.

China-Biotics Inc. (OTC:CHBT) – China-Biotics is one of the leading Chinese producers of probiotics, which are basically good bacteria for the gastro-intestinal tract. You can research probiotics on your own for more clarity, but it is a booming worldwide business that is estimated to be growing at +20% a year, and sometimes even faster in certain markets. China is one of those markets. As the middle class in China gradually rises up, there will be more demand for health foods and specialty items that could take advantage of probiotics. We already do it here in the United States, with products like Activia. There are also health food movements that use things like kefir and probiotic supplements to help keep the intestines happy. So why choose CHBT?

First, is the tremendous value. By any estimation, it seems that CHBT is vastly undervalued relative to their peers. One of their major competitors were bought by DuPont a few weeks ago for a premium on their share price. This automatically makes everyone else in the industry subject to takeover analysis, although CHBT’s price has yet to reflect this premium. This is a great opportunity to get in on a company that can a) capitalize on the increase in domestic consumption in China and b) provide both a great fundamental and relatively valued investment. There is a huge short position in the stock, amounting to over 30% according to Kapitall, but I am contrarian on that front and believe the shorts will be fruitless. It is only a matter of time before people realize that CHBT is too cheap. As a result of my confidence, I am assigning a price floor of $22 and a ceiling of $45 to CHBT. I think that there is tremendous upside to this stock, and would add it to a Chinese equity portfolio in a heartbeat.

Conclusions: I think there are some risks investing in Chinese stocks. There is a risk of the unknown and paranoia about intangible, immeasurable risk. There is language risk. There is a risk that shorts will eat your lunch. There is risk that the company simply doesn’t exist.

I strongly suggest that you take investments in these companies with the knowledge that there may be some skeletons in their closets. That being said, of the companies out there I find these to be the most potentially rewarding. I would also strongly suggest that you not invest in one company, but instead diversify your holdings among companies that touch different parts of the People’s Republic. For those of you that have risk tolerance and want to get in on the next BIDU before it has BIDU multiples, check out these stocks, do your due diligence, and see if they fit into your investment profile.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.