5 Stocks To Short For The China Bear, 2 Stocks To Go Long

by: Ethan Backus

Unfortunately for the China Bear investor, China’s financial system is the most closed-off of the world’s major economies. Making investments, much less shorting their stocks directly, is difficult. After the Chinese reverse-merger stock meltdown this year, there are few attractive short candidates trading on U.S. exchanges. Moreover, the Chinese stock market in general seems to be anticipating a crash in the Chinese economy, since the Shanghai market is one of the world’s worst performing these past few years, with the market P/E being very low and the financial sector P/E being around 6! This combined with possible continuation of an advancing Yuan against the U.S. dollar makes shorting a broad Chinese index ETF such as (NYSEARCA:FXI) potentially dangerous if stocks rally or the Chinese economy doesn’t in fact slow down.

So, the most prudent strategy for taking advantage of a possible Chinese slowdown is to incorporate shorting Chinese stocks into your general hedging strategy, since Chinese listed stocks tend to move with the general market anyway. It seems best to short Chinese stocks that are unattractive independently of their status as Chinese stocks. Stocks with high P/E ratios with unsustainable earnings, or stocks with questionable accounting and transparency fit the bill. With these stocks sold short in your portfolio and a well-selected number of long positions, you should do well. If the “grey swan” of a China meltdown arrives, then you will make stupendous gains.

That is the path of the enterprising investor. The defensive investor would be well advised to steer clear of Chinese stocks, large multi-nationals that depend on China for large parts of their revenues, or commodity stocks that have had huge run-ups in earnings in the last few years, and sell a majority of their product to China.

Stocks to Short:

1) Hyatt Hotels Corporation (NYSE:H) has been pushing into China with many new investment projects. A surprisingly large chunk of their revenue now come from China. The problem is that there has been a high-end hotel construction boom paralleling the general property boom, meaning that there are far more hotel rooms available today in China than are needed, and the supply is growing greater all the time. It is as if all the major hotel chains got the bright idea of investing massively in China all at once. The stock is selling at a high P/E of 92 with only a forward P/E of 41. However, it seems unlikely that the they will be able to increase profits that much. Their five year revenue growth is negative. Their five year profits are in a major downtrend. There doesn’t seem to be any future impetus to cause profits to justify such a high P/E at this point, especially with luxury spending cut by so many people after the start of the Great Recession. If their China revenues drop and investments there go bad, then this stock will really crater. The stock has a market capitalization of $6 billion, so it’s not a small cap stock huge growth potential, yet it is priced like one.

2) Guggenheim China Real Estate ETF (NYSEARCA:TAO) of course is the clear choice for shorting Chinese real estate, the major problem being the paucity of their shares to borrow for short selling and the illiquidity of their options contracts. This fund mostly includes Hong Kong real estate developers, but there is some action on the mainland as well. A few of the companies are REITS, which are less volatile, however the yield for this ETF is only .86%, which tells me that these companies are financially strained and can’t afford to give out cash to shareholders. With developers coming under so much strain in the last few months, it is possible that investors will sell out of these shares even before the companies start feeling major shocks. Hong Kong will likely continue to be an important financial center as its banks help organized crime and regional corrupt officials to launder their money, but the city's revenues linked to being the “gateway to China” seem to be in a terminal decline. Therefore, their real estate market ought not be in such a boom and is probably being temporarily affected by the real estate boom on the mainland.

3) Home Inns and Hotel Management (NASDAQ:HMIN) has recovered swimmingly from its October low of $22 up to $35. So, this would be a less dangerous time to short it. Their rapid expansion has been the source of their high share price and relatively high P/E, but it would also be the source of massive risk during a downturn in real estate or in the economy. Many of their new investments have been done at the very top of the market. This stock is not as overpriced as (H), but could carry significant hidden risk, especially if their accounting turns out to be as warped as many other Chinese corporations.

4) Global X China Financials ETF (NYSEARCA:CHIX) is a terrific short candidate because it has Chinese banks which will experience a lot of turbulence, but the tiny size of the fund makes finding its shares to short difficult.

5) China Southern Airlines (NYSE:ZNH) has been unprofitable for years, yet the stock continues to remain high. Airlines in general are great destroyers of investors capital anyway, so shorting this stock has that advantage as well. The risk of shorting this stock is that part of the company’s debt is denominated in dollars, and as the yuan advances against the dollar, revenue in yuan can be used to more easily pay off the fixed dollar debt, thus boosting profits. Additionally, over the next few years the government has pledged to do more to help fund and promote China’s airline sector and consolidate it. However, if they are having problems elsewhere in the economy, then they won’t be able to help out the airlines.

Stocks to Go Long:

1) Wal-Mart (NYSE:WMT) would benefit from a slowdown in China because it would reduce their product costs. Inflation has caused the monthly wages of many factory workers to double in the past 15 months, driving up the production costs. A fall of in demand from Europe and America would cause factories to produce goods at cost to sell to Wal-Mart just to maintain cash flow. Also, the appreciation of the Yuan against the Dollar is causing prices for Wal-Mart to go up, so if the Chinese suspended Yuan appreciation, as they did in 2009, then that would mitigate upward pressure on prices which seem at this point to be a fait accompli. Wal-Mart has the best coordination of purchasing in the world, if there are opportunities to extract price concessions from vendors and factories, Wal-Mart is best situated to do so. Wal-Mart's investments in China in terms of stores is negligible, mostly unprofitable and perhaps doomed to mediocrity anyway.

2) China Mobile (NYSE:CHL) would be well positioned to survive a downturn in the Chinese economy. Their vast scale would help them ride it out. Furthermore, other telecom companies like China Unicom (NYSE:CHU) - another great short candidate – have invested heavily in subsidizing people’s transitions to smart phones. If the smart phone market doesn’t retain its rapid growth in China, then China Mobile could pick up more market share and sales from its beleaguered rivals. China Mobile has a low P/E of 10 and has a great dividend of about 4%. You could use a position in China mobile to hedge against shorts in less solid stocks. Also, China Mobile has made the switch to 4G for their network, which could be a huge strategic asset in the coming years.

Disclosure: I am short H, TAO, HMIN.