The Secret to Choosing Chinese Stocks

by: Shaun Rein

Last week Finance Asia profiled me in a piece entitled “Shaun Rein’s Research Turns Up Golden” written by Dan Slater. The article mentions briefly four of my top picks for Chinese stocks in the coming quarter: Ctrip (NASDAQ:CTRP), China Mobile (NYSE:CHL), New Oriental (NYSE:EDU), and Netease (NASDAQ:NTES).

As I mentioned in a previous article for Seeking Alpha, the volatility in the US markets will have little impact on Chinese companies that focus on China’ emerging middle class whose personal fortune will not be affected by downturns in the stock market or mortgage mess.

These 4 companies are increasing revenues and profits because they have sustainable business models. Their profits are not based on the companies’ investments into the Chinese A-share market as too many companies traded in Shanghai are but on service superior to what is offered by their competitors. Ctrip, for example, continues to do a much better job of serving its competitors than its closest rival Elong (NASDAQ:LONG). One runs into Ctrip employees passing out membership cards in railway stations and airports throughout the country. With the move towards e-ticketing and this constant marketing blitz, Ctrip is positioning itself strongly for the long-term while Elong flounders. This might explain why all but Netease are near all-time highs as smart investors poured money back into China in the past month. But as liquidity concerns ease with the Fed’s move yesterday, I still see upward momentum for these 4 stocks in Q4.

However, I personally am very concerned about the long-term health of Chinese banking stocks, which one can get exposure to through the iShares FTSE/Xinhua China 25 Index (NYSEARCA:FXI). In the next few months FXI will probably be a good place to park money but in the long-term the situation is a little scarier. Chinese banks, which are over-weighted in the index, are poorly run institutions and they are attracting the ire of Chinese consumers fed-up with abysmal customer service. I wrote about this before in BusinessWeek, which is why Chinese youth are using the services of firms like Alibaba and Tencent’s Q coins for the online transactions.

The other day I waited in line for almost 2 hours at a Bank of China branch to make a simple transaction that could have been handled online in the US at a bank such as Bank of America (NYSE:BAC). Banks in China are simply not emphasizing customer service. A few months ago I spoke at a conference in Beijing where one of the heads of the Bank of China was also speaking. He answered a question about the encroachment of foreign banks and their emphasis on customer service and how that might change Bank of China’s strategy.

He announced bluntly that they focus very little on retail consumers because their main mission is to service state-run enterprises and loan massive amounts to them. His conclusion was the Bank of China had more branches and that was enough to placate consumers and that he did not worry about HSBC (HBC). Such foolhardiness runs through the executive suites of many of these banks as they are promoted not so much on money-making grounds.

According to interviews we have conducted with affluent Chinese in Beijing, Shanghai, and Guangzhou, his statements ring hollow with consumers – and they are moving with their wallets to banks like China Merchants or Huaxia or the foreign ones like Citibank (NYSE:C) that emphasize customer service and offer a wider array of consumer finance products like co-branded credit cards. One female investment banker said, “It makes my blood boil to go to Bank of China. The lines and service is terrible. I have opened up a VIP account at Citibank”. Like in the retail environment, which is seeing Best Buy (NYSE:BBY) trump Guomei, Chinese consumers want nice environments with good service for their banking needs. They actually demand it more with financial institutions because they are not looking for a bargain priced Motorola phone (MOT) – they are looking to safe-guard their financial well-being.

In recent times, the Chinese banks have made a ton of money lending money to SREs that pile the money into the A-share market. Even increasing interest rates have not slowed investment because firms have been seeing triple digit returns and continue to focus on investing. It is as is there are millions of hedge fund managers running amok in China with domestic banks feeding the fire in order to sustain their numbers.

Ultimately Chinese banks will not be able to continue ignoring retail customers and this will be reflected in falling numbers and then stock prices once the A-share market cools off. I would keep my eye on FXI to be able to get out if and when Chinese retail investors panic and start to take money out. Prices will drop and companies will stop borrowing from the banks.

The companies that will continue to perform well are those that serve China’s middle class and serve them well.

CMR analyst Ben Cavender contributed to this article.

Disclosure: Shaun Rein owns shares of China Mobile.