Street Patrol
Made-in-China stocks are cheap
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Prices for Chinese stocks have been pushed down by more public offerings and profit-taking, among other factors. But the country's continued growth means robust earnings for many companies there.
By Robert Walberg
It’s been a torturous year for Chinese stocks that trade in the United States. Just look at the performance of some key names: China Yuchai International (CYD, news, msgs), down 56%; Nam Tai Electronics (NTE, news, msgs), off 35%; Chinese Automotive Systems (CAAS, news, msgs); down 30%.
A recent interest-rate hike by the People’s Bank of China, a rise in new offerings and profit-taking all contributed to the group’s lousy performance this year.
But as investors plan their course of action for next year, they'll want to take advantage of the retreat and increase exposure to this booming region while prices are cheap.
Cheap might be a word associated with Chinese exports, but it hasn’t been used for some time to refer to Chinese stocks, which trade here as American depositary receipts (ADRs). Yet of the 11 stocks I looked at, the average price-to-earnings ratio based on estimated 2005 earnings is a scant 15.8. Back out the relatively high-priced Internet-related companies such as Chinadotcom (CHINA, news, msgs) and Ctrip.com International (CTRP, news, msgs), and the average P/E ratio falls to an even lower 11.5.
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So should you.
Of course it should be noted that few of these companies have wide followings on Wall Street, so the earnings estimates come from a limited number of analysts; in several cases, it’s just one. Still, it seems reasonable to assume that the stocks are cheap, at least by historical standards. Even if the Street is being too optimistic by 10%, the group would still be cheap relative to the market.
What’s more, Chinese companies are likely to benefit from an explosive economy for years to come. Bolstered by strong exports, infrastructure improvements and an expanding middle class, China has average GDP growth of 9.3% over the past two years, more than double the U.S. growth rate.
Slow it down
Meanwhile, the Chinese government is taking steps to prevent the type of hyper-growth that often precedes a prolonged downturn, such as what Japan experienced. If the government succeeds in maintaining GDP growth in the high single- to low double-digit range, there’s every reason to believe that Chinese companies will continue experiencing robust growth as well.
Strong growth and cheap prices is an attractive one-two combination on Wall Street, and one that's increasingly difficult to find. Consequently, when you come across such a find, you want to exploit it to the fullest. How best to do that in this situation?
One way is to invest in country-specific mutual funds. There are several tied to China, but most are littered with relatively high fees.
Another way would be to buy shares in one of the new Chinese exchange-traded funds, the iShares FTSE/Xinhua China 25 Index Fund (FXI, news, msgs) or the PowerShares Golden Dragon Halter USX China Portfolio (PGJ, news, msgs). The former invests in stocks listed on the Chinese and Hong Kong markets, while the latter invests in Chinese companies trading on U.S. exchanges. Both give investors simple ways to diversify their assets without having to spend much time researching individual companies. That’s a feat made more difficult when investing in overseas companies given different accounting rules, limited availability of information, etc. On the downside, the ETFs are heavily concentrated in a few industries.
Or investors can simply buy a number of individual Chinese ADRs. Though this approach offers less diversity, it’s relatively cost-effective and allows you to pick and choose the most appealing candidates. Considering that foreign stocks most likely make up a small percentage of your overall portfolio, this trade-off might be worth the added risk. If so, here are some stocks worth considering.
At the top
First and foremost is PetroChina (PTR, news, msgs). With revenues totaling more than $40 billion over the past 12 months and with a market capitalization of more than $95 billion, PetroChina is the biggest of the bunch. As the name implies, the company is engaged in the petroleum and natural gas markets. Earnings this year have been bolstered by higher prices for crude and chemicals. The company is expected to earn $6.56 per share this year, with earnings slipping slightly to $6.04 in 2005.
Despite the projected earnings decline, PetroChina is still cheap at only nine times next year's expected earnings and 2.3 times trailing 12-month sales. The stock is that much more compelling considering the company's operating profit margins of 32%, return on equity of 23% and a dividend yield of 4.4%. It should also be noted that earnings estimates are based on much lower crude prices, an assumption that might not prove true given production concerns and strong worldwide demand. An upward earnings surprise would only improve the stock’s long-term outlook. But even without such a plus, PetroChina has upside potential over the next six to 12 months to around $62 a share.
China Telecom (CHA, news, msgs) is another large-cap company with decent growth potential, attractive valuations and strong financials. The company is principally involved in the traditional phone business. With China’s improvements to its infrastructure and the expansion of its middle class comes increased demand for regular phone service.
Growth will also be fueled by the company’s move into wireless ahead of the much-anticipated launch of 3G services, or the next generation of wireless. Though earnings are expected to grow by an average annual rate of 14% over the next five years, the stock trades at just 12.4 times and 10.6 times estimated 2004 and 2005 earnings, respectively. By comparison, domestic phone companies trade at more than two times their projected growth rates. Merely assuming that China Telecom attains a multiple consistent with its long-term growth potential, the stock has upside over the next 12 months to the $51 to $52 per share range.
Limited downside risk
The final stock is a turnaround candidate, China Yuchai International. Dogged by deteriorating margins and somewhat disappointing earnings growth, this manufacturer of diesel engines and engine parts has badly lagged the market this year, reversing much of the stock’s big gain in 2003. Nevertheless, manufacturing companies traditionally do well during periods of economic expansion, and, considering China’s growth potential over the next few years, China Yuchai's outlook remains bright. In fact, the one analyst providing estimates on the company sees earnings jumping to $2.32 in 2005 from $1.73 this year.
Despite this rosy earnings outlook, the stock trades at only 5.8 times projected 2005 results and 0.74 times trailing 12-month sales. At these multiples, the downside risk seems limited because most of the bad news regarding profit margins has been priced in. Assuming management’s efforts to enhance margins prove successful and the company comes close to hitting estimated earnings, the stock should have little trouble rebounding to $18, or more than 33% above current levels.
Whether you choose country-specific funds, ETFs or individual stocks, the explosive growth potential of China’s economy combined with the relatively inexpensive price of its stocks listed on U.S. exchanges make Chinese stocks a must play in 2005.
At the time of publication, Robert Walberg neither owned nor controlled shares in any equities mentioned in this column.
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