The Contrarian Case for China: 3 Stock Picks - Analyst Blog

Following three successive days of losses, China's markets rebounded on Friday, managing to avoid losses for the week. Gains continued into Monday, with the benchmark posting its largest increase over a month. In both cases, the upward movement was fueled by speculation or concrete action on steps to be taken by the government to prop up markets and boost the economy.

Continuing efforts by the government to improve the situation means that the situation may not be as gloomy as it appears. In addition, conventional metrics may not be taking into account the inherent growth potential of China's companies. This means that it may still be a good option to add certain China stocks to your portfolio.

Steady Trade, Boom and Plunge

Approximately a year back, the Shanghai Composite index was holding steady around the 2,000 mark. This was similar to levels experienced since 2012. However, changes in official policy and additional liquidity sparked off a phenomenal bull run which ended this June. At that point, the index had hit 5,100.

The benchmark index declined 15% in July, marking its worst monthly losses since Aug 2009. The Shanghai Composite is now trading around the 3,600 mark. The majority of market watchers believe that it will be some time before it can once again make significant gains. Margin traders retreated from the market and the number of fresh equity accounts opened nosedived.

Sustained Government Efforts

A number of government measures taken to prop up markets resulted in a rebound of 12% from the low the benchmark had hit in July. China's government has taken a series of steps. Measures included suspension of trading for 1,400 and more companies, preventing shareholders from offloading stakes, delaying IPOs and providing a government agency with access to funds in excess of $480 billion to fund purchase of equities.

On the economic front, reforms of government owned enterprises have been accelerated. Authorities have also eased regulations on the purchase of real estate. This is an attempt to prop up a sector which was substantially responsible for the country's spectacular growth record but is now undergoing a slump.

Dismal Economic Data

Meanwhile, economic data continues to be uninspiring. Data on manufacturing released last week has been disappointing in nature, indicating underlying economic weakness. One section of analysts opines that the market needs to rebound by itself for investor sentiment to improve.

There was fresh evidence of an economic slump over the weekend. Producer prices declined to the lowest level in six years in July. Additionally, exports recorded a greater than expected decline.

Valuations vs Potential Earnings

The lack of fresh small investors has been attributed to fears that valuations are unsustainable in nature. Most analysts also take this view, but the Shanghai Composite has still gained 20% year to date. According to Bank of America BAC unit Merrill Lynch, the index's median (Enterprise value/EBITDA) was more than twice the average of the rest of the world in early July.

Analysts at Societe Generale Group SCGLY have said that it may not be a good idea to focus squarely on conventional valuation methods. This is because the potential of China's companies to deliver strong profits and dividends over the long term remains significantly high.

Currently, the median price-to-earnings ratio exceeds any of the world's top 10 markets. However, Societe Generale believes shares may move up 40% by the end of next year, despite a potential economic slowdown. It has also opined that profits for companies listed on the mainland exchange will increase by a minimum of 10% every year till 2017.

Further, around 29% of earnings are expected to be received by shareholders as dividends. This puts a very different turn on the valuation question, making such shares much cheaper than other Asian counterparts.

Our Choices

Despite recent reverses, China continues to exhibit strong economic potential. The government is making continual attempts to transform the economy into one powered by consumer spending. In this situation, a young and dynamic population which continues to grow is among its key strengths

At the same time, one cannot ignore the volatility China's market has been experiencing. In this situation, it may be prudent to select stocks on a case by case basis and hold onto them for the long term. Our selection is backed by growth and valuation metrics as well as good Zacks Rank.

China Eastern Airlines Corp. Ltd.CEA is involved in the transportation industry, and is the primary air carrier serving Shanghai, China's eastern gateway.

China Eastern Airlines holds a Zacks Rank #1 (Strong Buy) and the projected earnings growth is 106.4%.The forward price-to-earnings ratio (P/E) for the current financial year (F1) is 9.10.

New Oriental Education & Technology Group Inc . EDU is the largest provider of private educational services in China based on the number of program offerings, total student enrollments and geographic presence.

Apart from a Zacks Rank #2 (Buy), New Oriental Education & Technology has expected earnings growth of 24%. It has a P/E (F1) of 15.22x.

SmarTone Telecommunications Holdings Ltd.STTFY operates as a telecommunication service provider. It offers its services its services in Hong Kong, Mainland China, and Macau.

SmarTone Telecommunications holds a Zacks Rank #2 (Buy) and has expected earnings growth of 66.7% for the current year. It has a P/E (F1) of 16.61x.

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BANK OF AMER CP (BAC): Free Stock Analysis Report

SOCIETE GENL FR (SCGLY): Free Stock Analysis Report

CHINA EASTN-ADR (CEA): Free Stock Analysis Report

NEW ORIENTAL ED (EDU): Free Stock Analysis Report

SMARTONE TELECM (STTFY): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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