They’re all in China, some we have seen before…

We have selected these stocks on the basis of:

1. growth prospects. These companies operate in solidly growing markets
2. balance sheets. These companies have low debts
3. track records. The companies have been solid performers for some time
4. valuation. Most of these companies are surprisingly cheap, considering the first three points.

It is really rather surprising that while the Chinese markets are rather expensive, exactly the opposite holds true for the Chinese ADR’s (American Depository Receipts) trading on US markets.

So we  we have to tell you a few things about the peculiarities.

Chinese growth
It can’t be a surprise to anyone that for growth stories, China is the place to be. What is going on there is truly remarkable and transformative. Ten percent economic growth in a country with way over a billion people offers opportunities of a lifetime. These opportunities abound:

• Energy needs. Still building two new coal fired electricity plants a week, but the awareness is growing that China has to change track. Natural gas only provides 2% of its energy needs (we happen to know a company which can play a role here), and China will be the place for alternative energy (presently responsible for barely 1% of electricity production) for years to come..
• Commodities. That bull run in commodities would not be happening without China. It’s now the biggest market for most of these
• Infrastructure. Sound government finances have enabled the state to pour half a trillion dollars into upgrading its infrastructure
• Construction. Chinese growth depends on shifting people from low productivity rural activities to higher productivity urban industrial and service activities. The construction boom to
• Changing lifestyles. The ranks of the middle classes swell at an unprecedented pace, with that come a host of needs that can now be met, from changing diets to healthcare to transportation to housing, the possibilities abound
• Transportation. Just one figure tells the story, China has overtaken the US as the biggest car market in the world in 2009
• Modernization. China can leapfrog technologies, witness its buildout of a high-speed rail network. Even the problems modernization create (pollution, security, complexity, etc.) offer unprecedented opportunities for a host of industries and companies
• Retail. The shift to a more domestic demand led growth path has been exellerated by the financial crisis of 2008. Domestic consumption is growing at a 15%+ pace

One has to realize that China doesn’t only rely on cheap labour for export markets, especially since the big financial crisis. New growth sources have been opened up, like:

• An unprecedented move into upgrading its science and engineering base. Rather than relying on catching up with the West by just licensing technology, China is moving into the forefront of science and technology, creating it’s own base of knowledge, know-how, scientific and engineering communities. In short, China is creating a formidable systemof innovation on which to base the next phase of economic development.
• The “Commanding Heights”. A popular book describing the descending role of the steering capabilities of the state, China has never subscribed to that idea. And State-led capitalism has gotten a shot in the arm because of the excesses of unregulated capitalims, especially in financial markets. It’s economic model has been well suited to these times, enabling China to respond forcefully and directly to the economic crisis, with a massive stimulus program and ordering a large expansion in bank credit. While the merits of the latter remain to be seen, there is little doubt that the Chinese stimulus program has been a big success already. Apart from the inmediate effect of strengthening demand, these (mostly infrastructural) expenditures are strengthening the structure of the Chinese economy (a weak point in India, its main rival growth story), providing a platform for future growth.
• Huge and growing domestic market. Hundreds of millions of people just smelling the first whiffs of consumerism. The domestic market is already so large, and because of its fast growth, is potentially much larger still that it enables China to set technological standards for their own market, standards foreign companies cannot ignore. This has already happened in advanced mobile telecommunications, for instance.

All this doesn’t mean China doesn’t have a dark side. China is plagued with significant problems like bureaucracy, corruption, pollution, repression, ethnic problems, growing inequality, and the like. But the answer to all of these is continuing economic growth. China is like a bycicle, balance is only maintained above a certain speed, although no doubt there will be bumps on the road.

A nice backdrop we should also mention is that the Chinese Currency, the renminbi (measuring units are yuans) is quite heavily overvalued. Over the longer-term, this provides a one-way bet that is likely to add considerable extra juice to potentially already nice returns.

Some peculiarities of Chinese ADR’s
While the Shanghai listed stocks are generally very expensive (reflecting the earnings growth potential), there is something weird with many of the Chinese companies with an ADR listing on US markets, especially the smaller cap ones we’ll be focusing on. These are generally very cheap! What explains the difference? Some thoughts:

1. Shares listed on the Shanghai exchange cannot be shorted.
2. Shares listed on the Shanghai market are largely off-limits to foreign investors. Chinese shares listed on other exchanges are largely off-limits to Chinese investors.
3. China discount.

The first two points produce large and persistent valuation gaps between the domestic Chinese markets and those foreign markets where some Chinese companies are listed (like Hong Kong, although technically pertaining to China but as an exchange it’s really separate, or the US).

These value gaps pertain because no investor class has access to all these markets, hence there is no way to arbitrage these valuation differences away. And the curious thing is that the Chinese companies with (ADR) US listing tend to be cheap to very cheap (although this is changing as we speak, there is a significant rally going on in several of them) while their Chinese counterparts tend to be very expensive.

The Chinese markets are expensive because shares can’t be shorted there, because there is a bit of a speculative frenzy going on, and of course because the growth prospects of the Chinese economy are rather good.

Another thing to keep in mind is that without arbitrage mechanisms in place, there doesn’t have to be any correlation in price movements. However, the practice is that many American investors react to moves in the Chinese markets by selling or buying the Chinese ADR’s listed on the US markets, basically because they think there is a connection.

This is a situation in which one really can profit, as the ADR’s can be sold to a pulp, basically. One example, Fuqi International (FUQI) was sold to a truly ridiculous $3.31 per share early in 2009, not even 2x it’s 2009 earnings!

The lack of arbitrage has a downside though, there is a risk that the low valuations of ADR’s will endure, at least for the forseeable future. However, we think that the trend will be our friend here, not only will the Chinese markets be opened up more, Chinese will also be able to invest abroad one day. And cheap valuations are cheap valuations. Money doesn’t have a habit of laying around for too long on Wall Street (or anywhere)..

China discount
One might wonder why we’ll talk about a China discount while there seem to be plenty of reason for a China premium (which we set out above). However, for some reason these ADRs are surprisingly cheap, despite their bright prospects as companies operating in the fastest growing economy in the world.

One reason for that is that whether justified or not, Chinese ADR’s suffer from some reputational disadvantage pertaining to the quality of their corporate governance and the quality of their figures and auditing process.

We’re not at all convinced this is deserved, we merely note it. We are not aware of any study pointing to a significantly higher amounts of scams in Chinese companies, especially those with a listing on a large US market with all the obligations that produces. But it is perceptions, not necesarily reality rules.

To circumvent this as far as possible, there are a couple of investment rules we use:

• Diversify: do not put your money into a single stock
• Avoid companies listing on lesser exchanges as the OTCBB or (especially) pink sheets
• Avoid stocks with large outstanding debts. Smallcaps in general can be the victims of death-spiral financing construction (especially those with convertible bonds) which give the provider of finance an incentive to short as to maximize the number of shares upon conversion

Another reason why these stocks are so cheap is the preference for large caps during turbulent times, especially when applied to non-US small companies. However, we believe that this reason is rapidly disappearing and Januari is generally a good month for smallcaps.

So we will write extensively in the near future about companies such as:

1. Fuqi International (FUQI)
2. China Green Agriculture (CGA)
3. China Agritech (CAGC)
4. China Security & Surveillance Technologies (CSR)
5. China Fire & Securities Group (CFSG)
6. Cogo (COGO)
7. China Sun Group (CSGH)
8. Telestone Technologies (TSTC)
9. SmartHeat (HEAT)
10. Rino International (RINO)
11. Duoyuan Global Water (DGW)
12. HQ Sustainable Maritime (HQS)
13. China North East Petroleum (NEP)

And the like.