Watch out with Chinese smallcaps part III

Thorny problem. So many opportunities, so much danger lurking..
Earlier, Part I, Part II

Exposure to China: How to Play It Safe

by David Sterman

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 impressive income 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 Chinese economy, 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). Deer has built a strong relationship with Stanley Black & Decker (NYSE: 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 impressive cash flow growth and steady share buybacks. The fact that it sells for less than 10 times projected 2011 earnings 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 Chinese economy 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 (NYSE: 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 (NYSE: SI), and has laid out plans to generate 30% annual sales and profit 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.

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.

Original Post

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.