Investing in Chinese small-cap companies has turned out to be quite miserable the last two years. Because numerous accounting frauds were exposed, stock prices of the whole sector tanked and investors are licking their wounds. However, with the valuation so depressed, now may be the best time to invest in this sector, if one can identify honest, well-managed companies and if they have the courage to step in.
In my opinion, Xunyuan Real Estate Co. (XIN), a medium-size residential builder in China, is the kind of company that can offer the investor superior returns. I've followed XIN for over a year and have conducted extensive research on this company. I'm so convinced that this is a great company offered at a fire sale price that it's the biggest position in my personal stock account.
XIN became a public company via an IPO listing in 2007, with Merrill Lynch being its lead underwriter. Its auditor is Ernest and Young, a Big Four auditor. XIN has used Ernest and Young from the very beginning, even prior to its IPO. It currently has a 6% dividend yield that is very attractive in a low yield environment. All these factors are comforting but not good enough to prove that XIN is not a fraud. There is one single fact that significantly decreases the chance of XIN being a fraud, and that single fact is that XIN is in China's residential real estate industry.
It's the industry, stupid!
In the late 90s and early 2000s, China's real estate industry was like the Wild West in the US. Developers obtained land by signing purchase agreements with local governments and there was a lot of bribery and under-the-table deals. All this changed in 2003 when the Chinese government implemented a policy that requires developers to acquire lands via public auction. The purchase of the most important raw material for the industry, land, became very transparent. Once the land is secured, developers then submit detailed design proposals and estimated construction schedules to the local government to apply for construction permits. Once construction progresses to a certain stage that qualified for presale to the public, developers need to apply for presale permits. Information regarding the project such as the number of units, total square footage available for sale needs to be disclosed. Once a project is in the sales phase, all the project information appears on various real estate websites. Up-to-date sales information is also available on the website of the government's real estate department. Investors can also subscribe to a database maintained by the company such as CRIC to obtain even more detailed sales data regarding a specific project. CRIC maintains the most up-to-date information about almost every construction project in China.
Since information regarding China's real estate projects is readily available and easily verifiable, I believe it's not an easy task for a developer to play with their sales figures without getting caught.
XIN's financial metrics seem reasonable
Most of XIN's financial metrics are reasonable. As hard as I tried, I couldn't find any red flags calling for further investigation of fraud. Below I will elaborate on two financial metrics, revenue growth and profit margin, to demonstrate that XIN is a credible company.
China's real estate market experienced tremendous growth in the last couple of years. The table below shows that from 2008 till 2011, residential construction sales in China grew a whopping 135%. During the same time period, XIN's revenue only grew by 93%, much lower than the industry. In my opinion, this lower revenue growth is an indication that XIN is an honest but conservative company.
XIN Revenue vs Industry
Cumulative growth (08-11)
Unit: Million USD
1 USD = 6.3 RMB
XIN's profit margin is very modest when compared to its peers. The table below shows the profit margins for XIN and Vanke for the year 2008 till 2011. Vanke is the largest residential developer in China. XIN incurred a loss in 2008, because of a huge write-off on its project in Suzhou, and was profitable in the following years. The following table shows that XIN's margin is in line with that of Vanke from 2009 till 2011.
Profit Margin XIN vs Vanke
XIN currently trades at a price earning (P/E) ratio of under 2 and a price book (P/B) ratio of about .30. The price is simply too attractive if one believes XIN's numbers are real. For investors with high risk tolerance, XIN presents a wonderful investing opportunity.
Disclosure: I am long XIN.