Are You Short or Long China?

by: Aidis Zunde

China has a booming economy with great potential for continued long-term growth. Chinese shares, both in Shanghai and in other markets, have skyrocketed over the past several years. Now, as U.S. exchanges head lower, is it time to buy or sell Chinese stocks?

During 2006 and the first part of 2007, I had a significant amount invested in Chinese financial, industrial, and consumer discretionary shares. At that point, valuations became too rich for me and currently I only hold Guangshen Rail (GSH). Despite my pessimism, and that of many others, Chinese shares just kept going up for most of the rest of 2007! In recent months, however, the Chinese market has experienced a significant correction -- the iShares FTSE/Xinhua China 25 Index (FXI) is down about 34% from its October highs.

Despite that, the valuations on some Chinese stocks still appear to be unsustainably high. New Oriental Education and Technology (NYSE:EDU) trades at a P/E of 53.06; with 5-year growth estimates at a generous 30%, this gives it a P/E to growth ratio (NYSE:PEG) of 1.74. ReneSola (NYSE:SOL), down from an IPO high of $82 to $10.63, is still rich at a P/E of 30.63. (NASDAQ:CTRP) commands a P/E is 88.63, also well above estimated growth. Home Inns & Hotels Management (HMIN) has a P/E of 105.16 -- even if the company achieves projections of 40% growth annually over the next 5 years, that pricing still produces a very rich PEG of 2.63!

China Finance Online (NASDAQ:JRJC) is priced even more expensively; at $21.22, it has a P/E of 172.52. Of course, these shares may still go higher -- high prices by themselves are no indication of a coming correction. John Maynard Keynes pointed out: "The market can stay irrational longer than you can stay solvent." Last year, "rational" investment plays against Chinese equities would not have brought pleasant results. Even with the recent slump in value, the FXI is still over 50% higher than it was a year ago.

Eventually, though, slowing world growth and the decreased rate of demand will also impact the Chinese economy, just as rational expectations will impact the Chinese market. As the economies of the developed world slow, it is unrealistic to believe that the economies of Asia can totally decouple from the effects of that trend. These markets will also feel the pain of a prolonged slowdown in the West. At that point, those shares with the most inflated expectations will suffer the worst.

Yet, as mentioned earlier, there has already been a large correction in the value of Chinese shares. The FXI is down 34% since October. The trailing twelve month P/E now sits at 17.88. Many shares trade below that level.

Without much doubt, the Chinese economy holds much promise. It is a secular growth story, as both production capacity and consumer demand continue to increase. Chinese stocks, taken as a whole, are quite promising as a very long-term investment theme. However, during that long-term trend, there will be very significant up and down cycles -- buying in at the wrong time could result in losses to principal that may take a long time to recoup.

Therefore, in answer to the question I posed at the beginning, it is a "stockpicker's market." That is perhaps a glib and easy answer, but I do not see a better one. At this juncture, it is too risky to forecast the general direction of the Chinese market -- the combination of winter snowstorms, the large correction that market has already undergone, continued strong growth in the Chinese economy, rising inflation, the impact on exports of slowing growth in the developed world, and the upcoming Olympic games (to name just a few) make for a complicated and volatile mix...

However, careful research should be able to isolate a few reasonably-priced companies that offer potential for significant appreciation. Over the next few weeks, I intend to closely watch the Chinese market for signals that it is time to invest more money in some of these companies... At the moment, I am watching China Life Insurance (NYSE:LFC), China Petroleum and Chemical Corp. (NYSE:SNP), and Xinyuan Real Estate (NYSE:XIN), among others. Of the higher P/E shares, Focus Media (FMCN) is one of the few that have my interest.

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