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Making sense of China's stock markets--and their investors
03/25/2011 11:30 am EST
For today forget about sectors and trying to map economic and monetary policy out of Beijing. Put fundamentals back on the shelf. Give your technical indicators a day off.
Instead think about how investors in the markets of Shanghai, Shenzhen, and Hong Kong believe they can make money in these markets. In other words think about where they believe profits lie in their stock markets. And then let their sense of the sources of profit opportunities drive your understanding of these markets.
Let me explain.
Every day we try to make some kind of logical order out of the Brownian motion of the day-to-day volatility of stocks.
We say, Oil stocks are up or down. Money is flowing into or out of big cap stocks. Investors are seeking or abandoning the safety of consumer stocks.
But it’s important as we use this kind of logical shorthand that we remember it is shorthand and that we don’t confuse such objective qualities as “oiliness” or “big capness” or “consumerness” with what actually drives stock prices in the day to day. It’s not membership in the oil sector that moves oil stocks on any particular day, for example, but the ever-fluid preferences of investors for oil stocks.
The incredible volatility of stock prices is ultimately an expression of the volatile emotions and logic of hundreds of millions of investors. Thinking of that makes the project of finding some order in the stock market seem laughably naïve.
But there are patterns to investors’ relationships to stocks. We express some of them in cynical observations about human nature such as “Stocks are the only thing people want more of as they get more expensive.” Or we note the ownership life cycle as a former growth stock such as Microsoft (MSFT) ages toward a value stock, losing one type of investor as it picks up another. We know that many institutional investors can’t buy stocks priced below $10 a share and that others can’t buy stocks that don’t pay dividends.
All those relationships between stocks and stock investors organize a stock market—and the strategies that investors use to search for profits.
Those relationships exist too in the world’s newer financial markets such as China or Brazil. They’re relatively unstudied in comparison to the markets in New York or London, for example, since these markets are so new and because these markets are unfamiliar to most of the overseas investors who have started to buy stocks in them. We overseas investors may buy Chinese stocks but we don’t belong to those markets, and we don’t, at least at this point in the development of these markets determine the psychological structure of those markets. Those structures are largely determined by the everyday inhabitants of those markets.
I’m a student here myself but I think I can make three big, sweeping, but still useful generalizations about that structure in China’s markets.
First, stocks of state-owned enterprises behave in many ways like ETFs (exchange traded funds) in the U.S. market. In the U.S. markets ETFs are an easy way to place a bet on a sector. Want to overweight gold or agricultural commodities or financials? Buy into an ETF that specializes in that sector. Investors don’t pay a whole lot of attention to fundamentals such as price-to-earnings ratios or price-to-sales ratios when they make these buy and sell decisions. The buy or sell decision is much more often based on a technical or fundamental trend. We buy because the chart says the momentum is upward or because commodity prices and hence farm profits are climbing.
In my experience shares in China’s huge state-owned enterprises occupy roughly the same stock market ground. Investors buy shares of Jiangxi Copper (JIXAY) when they think the economy is expanding and demand for copper is on the rise. They buy shares in one of the country’s big construction companies when they think the government is about to increase infrastructure spending. They buy shares in one of the railroad equipment makers when the government increases that line in its budget.
Does anybody study the income statements and balance sheets before making one of these buys? Not in my experience. These companies are all profitable on paper but few make money once all costs are accurately distributed. Very few investors trust the books at state-owned enterprises, but for the purpose these stocks play in the financial markets that’s relatively unimportant. They act as chits that allow investors to make bets on big trends.
Second, the hot new stock—a current or recent IPO in many cases—serves as a way to bet on the very idea of China’s growth. Owning shares of the “next big thing” whether it’s an Internet travel company, a wind turbine maker, new carmaker, or a new drug company is a bet not so much on a particular company as on the idea of economic growth in China per se. It sure doesn’t hurt that everyone knows that most new offerings are priced to guarantee big profits to those investors with an inside track to buying shares before they’re initial trade. That just reinforces the idea that these new companies are an option on future growth.
Third, there are the stocks, in ever increasing numbers, where what does count are such things as strategies, market share, profit margins, and management skills. Here we find the shares of companies that are engaged in the difficult transition from the idea of growth to the concrete achievement of growth. Once upon a time, it was enough, for example, for Mindray (MR) to be in the business of making diagnostic equipment for hospitals and clinics. Now Mindray has to figure out how to meet the challenge of Western equipment makers that are counter-attacking in the middle of the market. Once it was enough for Home Inns and Hotels Management (HMIN) to be the fastest growing hotel chain in China. Now the company has to generate profits at a level that justify its investments in new hotels.
At the moment this is the most frustrating part of the market to invest in. Information is spotty and often of dubious reliability. Management track records are tough to evaluate and ownership structures are often murky. And valuations are frequently so high that they leave very little room for disappointment.
But in the long-term I think this is the part of the market that will be best source of profits for investors. As real companies produce real numbers that are sometimes disappointing to the investors who bought into the idea of growth, valuations will come down. That will give investors who do their homework a chance to make real profits if they can separate actual profitable growth from the promise of growth.
For example, as I posted recently http://jubakpicks.com/2011/03/22/too-much-growth-for-home-inns-and-hotels-hmin/ I don’t know how the growth story at Home Inns and Hotels Management is going to work out over the next year or two. It is possible that the company is biting off more growth than it can chew. But the company is starting to put up numbers that I can analyze in the same way that I analyze growth at any developed world stock. Revenue for 2010 grew by 22%. Operating profit climbed by 120% (although this number is still based on some special-pleading accounting). Diluted earnings per American depositary share came to $1.26. And the stock traded at a price-to-earnings ratio of 29.
Stocks like Home Inns don’t make up the bulk of the action yet in Shanghai, Shenzhen or Hong Kong. They certainly don’t represent the majority source of profits in those markets. And I wouldn’t suggest investors concentrate only on this part of the market now even if I believe this part of the market is its future.
Right now, I’d keep on playing all three parts of the market. There are good profits to be made in each. Especially if you remember that each one plays by different rules.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Home Inns and Hotels Management and Mindray as of the end of January. For a full list of the stocks in the fund as of the end of January see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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