Throughout much of the past year, a variety of financial
websites -- including this one -- noted the sharp disconnect
between projected growth rates and the price-to-earnings (
P/E
) ratios of many Chinese companies. It was easy to find companies
growing 20% or even 30% while sporting only single-digit P/E
ratios.
For some, that disconnect was based on fears that the Chinese
economic juggernaut would soon cool. For others, the inability to
really know if these Chinese companies were legitimate was the main
reason to avoid Chinese stocks. Increasingly, it's those latter
concerns that now rule the roost. An increasing number of Chinese
companies are in the sights of short sellers, as they allegedly
have little or no actual business underlying the seemingly
impressiveincome statement figures.
Case in point:
China MediaExpress Holdings (Nasdaq: CCME)
. The company operates a massive advertising network on buses that
ply China's regional highways. Several short-sellers have attacked
the company, noting that channel checks showed that many of the
company's claims were vastly overstated or were outright
falsehoods.Shares of China MediaExpress have fallen nearly 50%
since establishing a 52-week high of $23.97 on January 28 as
long-focused investors grew spooked by the allegations.
To be fair, these short-sellers have their own agendas, and it's
still unclear if their allegations are true, or if they are simply
"talking down a name." True or not, the game has changed for this
and many other Chinese stocks. It may be a long-time before their
reputations can be re-built.
Tightening standards
This has certainly been a wake-up call for me. I have recommended a
number of Chinese stocks in the past year. Some stocks have moved
up nicely, while others have stayed put with their low P/E
multiples. Looking ahead, I think it's still crucial to gain
exposure to the Chineseeconomy , but it's clear that standards need
to be elevated. That means you should look at Chinese companies
that have been publicly traded for more than a year (ruling
out the tidal wave of 2010 Chinese IPOs), companies with
well-respected global auditors, and companies with ties to major
multi-national firms.
As an example, I remain a big fan of
Deer Consumer Products (Nasdaq: DEER)
. [Please read here for my initial write-up of the company.] Deer
has built a strong relationship with
Stanley Black & Decker (
SWK
)
, and the company supplies that global brand with a wide range of
kitchen counter-top appliances. If Deer were falsifying details of
that relationship, Stanley Black & Decker would surely have
spoken up by now. As an added kicker, Deer has a rapidly-growing
business selling wares in its Chinese home market under its own
brand name.
Deer has been, and will remain, a solid growth story, highlighted
by impressivecash flow growth and steady share buybacks. The fact
that it sells for less than 10 times projected 2011earnings has
everything to do with the stigma associated with Chinese stocks. As
time passes, the better companies, like Deer and others, will be
able to shake that stigma.
Fulfilling needs
Make no mistake, the Chineseeconomy still represents the most
dynamic environment available to investors. To really capitalize on
the ongoing boom, you need to figure out what the
economy
needs, and which companies are stepping up. My colleague Andy
Obermuller, editor of
Game-Changing Stocks
, rightly identifies water quality issues as a real concern in
China. And his recommendation of
Tri-Tech Holdings (Nasdaq: TRIT)
is a solid one.
What Andy didn't mention is that Tri-Tech works with U.S.-based
auditors who have repeatedly scrubbed the company's books to verify
their accuracy. Interestingly, however, even this is not good
enough for the analysts at Global Securities, who suggest that
Tri-Tech's current auditor, Bernstein & Pinchuk, may lack the
stature to truly earn investors' respect. "We would like to see the
company upgrade its auditor to a top 10 recognized auditing firm,
and we believe that this is likely to occur after the company files
its
10-K
. If this were to occur, we believe the stock would receive
multiple expansion from current levels," they wrote in an early
January note to clients. Right now,
shares
trade for less than nine times projected 2011 profits, even as
profits are growing at a 40% clip.
I'm also a fan of
Concord Medical (
CCM
)
, which is quickly cementing its role as the leading player in
cancer diagnostic centers. Concord has been in business for 15
years, has key relationships with major medical device firms such
as
Siemens (
SI
)
, and has laid out plans to generate 30% annual sales andprofit
growth. The company's auditor: Ernst & Young.
Spreading the risk
There's another, simpler, way to gain exposure to China while
avoiding the risk of owning a fraud. Go with fund managers who have
been in the region for an extended period and are able to spread
their bets around in a number of companies. The
Matthews China Fund (Nasdaq: MCHFX)
has been operating for more than a decade. The fund has returned an
average of 18% a year in the past 10 years, and gets a four-star
rating from Morningstar. Fund manager Richard Gao has been at the
helm for more than a decade and "works with a big team of Asia
experts," according to Morningstar.
Action to Take -->
Despite the real concerns associated with Chinese companies, you
need to stay involved. My suggestions noted above are a good place
to start. The Chinese middle class is only just now emerging and
will fuel rising demand for goods and services for the foreseeable
future. I wouldn't be surprised to see the Chinese economy stumble
at some point in the near-term, but that should merely prove to be
a hiccup on the long-term path to growth.
-- David Sterman
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Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.