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China Is Looking Good In The Fourth Quarter

The world watched in wonder - and envy - as China blasted into the global economy, generating year after year of record results. However, similar to other recent headlines, suspicions of performance enhancing activities turn out to be valid. As is now widely accepted, China's double-digit growth was driven by true market expansion injected with a hearty dose of synthetic growth hormone.

China still keeps things close to the vest relative to other countries; however, as the second-largest participant in an increasingly global, and thus collaborative economy, China's ability to keep its economic issues under wraps is decreasing daily. Further, as the rest of the world tries to pull itself back from the proverbial fiscal cliff without the use of steroids, it falls on China to do the same. Clearly, Beijing recognizes this, as evidenced by its loosening the reins on the renminbi, progress with the PCAOB on transparency, and a stated plan to increase the minimum wage, which is why I believe that the economy still represents substantial opportunity and is certainly the closest to providing liquidity for investors.

As China addresses the economic and social issues facing its economy head-on, look for a turnaround in the sectors that are currently experiencing a slowdown; steel, construction, equipment manufacturing. I particularly like companies in sectors that will participate in the stimulus funded projects outlined by the National Development and Reform Commission in September, which includes 25 new subway lines, 13 new highway projects spanning thousands of kilometers, and other large-scale projects related to airports, energy production and wastewater treatment plants.

Market reaction to the stimulus announcement was positive, providing much needed optimism for investors around the world, and rightly so. However, just like the sports fans that will now have to deal with the accomplishments of mere mortals, long-term investors should be looking for fundamentally strong companies with management teams committed to sustainable growth rather than those that forsake the long-term for the next quarter. Companies that had sufficient resources to survive the downturn, and are taking the opportunity to make the necessary improvements and investments to hit the ground running as the world rebounds, are worth taking a look at.

Consider China's steel sector, which today accounts for nearly half of global output and an estimated 65% of the world's iron ore, up from10% in the early 1990s. That trajectory was hit hard by the global economic slowdown and ensuing decrease in demand, forcing steel manufacturers to deal with vast oversupply and pricing pressure, in addition to government efforts to consolidate the industry and eliminate less efficient operators. Those without sufficient resources have not remained in business or found themselves swallowed by larger operators. Most others saw profitability decline, if not disappear; according to the China Iron and Steel Association, of the 81 steel-makers it tracks, nearly half recorded losses in the first seven months of this year.

However, those firms with staying power are quietly regrouping, making strategic shifts in anticipation of the day existing inventories run out. And rest assured, with stimulus projects like the Xiamen subway system, which is set to include 150 miles of subway tracks and 138 subway stations, and the 20 new airports planned for Hunan in the next 15 years, that day will be here relatively soon.

Manufacturers are not only looking to improve operating efficiencies, they are turning to technology, specialty products, and strategic relationships to distinguish themselves competitively. This is particularly true for smaller companies that have the ability to make and implement strategic decisions relatively quickly as compared with the state-run manufacturing behemoths.

For example, China Gerui Advanced Materials Group (NASDAQ:CHOP) recently announced that it continues to operate profitably and increase production - albeit at a slower rate, while working on new product initiatives and specialization in order to grow its customer base. Sutor Technology Group Limited (NASDAQ:SUTR), a specialty steel manufacturer, remains profitable by seeking new customers and entering joint ventures with strategic partners.

China Industrial Steel Inc. (OTCPK:CDNN), a small steel manufacturer located in Handan City in Hebei Province currently operates four production lines with an aggregate production capacity of 2.3 million metric tons of steel per year, which is sold entirely to the domestic market. Profitable since inception, the company is shifting its focus to more specialized steel products such as Galvalume, a coated steel product used in the automotive and home appliance markets, in order to take advantage of the opportunities it sees in the market.

Conclusion

We should expect some fits and starts as China moves toward sustainable growth, but evidence points to a turnaround starting in the fourth quarter. This is particularly true for companies that will contribute to the much-anticipated domestic growth and infrastructure, such as steel manufacturers. Improvements in revenue and profits will likely come more slowly than in the past, but this should not deter investors looking to participate in China's growth. Companies that were able to not only survive the past year, but also implement strategic tactics for growth, such as CHOP, SUTR and CDNN, will undoubtedly generate positive returns for their investors.

Caution

Investing in companies in emerging markets, including China, is not suitable for all investors, and can be risky. It's important that investors thoroughly perform their own due diligence and analyze the potential risk.

The companies mentioned are listed on Nasdaq and the NYSE but have operations based in China. But they are all U.S. reporting issuers, and subject to the reporting requirements of the U.S. Securities and Exchange Commission, so U.S. transparency and disclosure is available to investors.

Source: China Is Looking Good In Q4

Additional disclosure: I am long CDNN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.