3 Keys to China's 3 Markets

03/25/2011 9:00 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

Stocks in that emerging giant come in three distinct types. Knowing which is which can make a big difference in how you play them and how much you make.

If you want to figure out China's stock markets—and hence China's stocks—start by dividing investments there into three parts.

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. Then let their sense of the sources of profit opportunities drive your understanding of these markets.

Let me explain further.

Making Sense of 1.3 Billion Investors
Every day, we try to discern some kind of order in the Brownian motion of day-to-day stock volatility.

We say that oil stocks are up or down. Or that money is flowing into or out of big-cap stocks. Or that investors are seeking or abandoning the safety of consumer stocks.

But as we use this kind of logical shorthand, it's important that we remember it is just shorthand. We must also be on guard that that we don't confuse such objective qualities as "oiliness" or "big-capness" or "consumerness" with what actually drives stock prices from day to day.

It's not membership in the oil sector that moves oil stocks on any particular day, for example, but rather 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 in investors' relationships to stocks. We express them in such cynical observations about human nature 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 help organize a stock market—and thus the strategies investors use to search for profits.

New Markets Follow Their Own Rules
Those relationships also exist in the world's newer financial markets, such as China and Brazil.

They're relatively unstudied in comparison with the markets in New York or London, for example, both because those emerging markets are so new and because they're unfamiliar to most of the overseas investors who have begun buying 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—determine the psychological structures of those markets. Instead, those structures are largely determined by the everyday inhabitants of those markets.

I'm a student of China myself, but I think I can make three sweeping, yet still useful, generalizations about the structure of its markets.

NEXT: Three-Fold Investment Advice |pagebreak|

1. State-Owned Enterprises Are Basically ETFs
First, stocks of state-owned enterprises behave in many ways like exchange-traded funds do in the US market. Here, ETFs are an easy way to place a bet on a sector. Want to overweight gold? Agricultural commodities? Financials? Buy into an ETF that specializes in that sector.

Investors don't pay a whole lot of attention to fundamentals like price/earnings or price/sales ratios when they make decisions on whether to buy or sell. Those decisions are 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 a railroad-equipment maker when the government increases that line in its budget.

Does anybody study 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 markets, that’s relatively unimportant. They act as chits that allow investors to make bets on big trends.

2. IPOs Are a Symbolic Bet on China’s Growth
Second, the hot new stock—in many cases, a current or recent IPO—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, a 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 itself.

And it sure doesn't hurt that everyone knows that most new offerings are priced to guarantee big profits, at least for those investors with an inside track to buying shares before the initial trades. That further reinforces the idea that these new companies are an option on future growth.

3. Real Stocks Increasingly Mean Real Opportunities
Third, there are the stocks—in ever-increasing numbers—for which such things as strategies, market share, profit margins, and management skills do matter. 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 Mindray Medical International (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 counterattacking in the middle of the market.

Once it was enough for Home Inns & Hotels Management (HMIN) to be the fastest-growing hotel chain in China. Now the company has to generate profits at a level that justifies 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; 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, I don't know how the growth story at Home Inns & Hotels 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 in 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 share (meaning the American depositary shares) 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 of profits in those markets. And I wouldn't suggest investors concentrate only on this part of the market, even if I believe it is the market's future.

For now, I'd keep playing all three parts of China's markets. There are good profits to be made in each part.

Especially if you remember that each one plays by its own rules.

Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX ), may or may not now own positions in any stock mentioned in this column. 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 here.

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