4 Good (and 5 Bad) China Stocks

10/19/2012 11:46 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

A recent bounce in this overseas market suggests a rally ahead, possibly a big one. And if you time it right, some "bad" picks can be good investing ideas, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

If China's stock markets are headed into a major rally, it's time to take a look at what I call "good" China stocks and "bad" China stocks.

It's too early, in my opinion, to be sure that we're going to see one of those explosive 40% to 80% moves off a bottom that China's equity markets deliver from time to time. But I do expect a rally worth buying.

So in this column, I'll give you the names of stocks I'd put in each category—four "good" stocks and five "bad" stocks. And I'll end with some thoughts on how to use them as this potential rally approaches.

The Bounce Is On
We have seen a huge drop in the Shanghai Composite Index, which in late September was down 70% from its October 2007 levels, but things are changing.

The index bounced off the psychologically important 2,000 level on September 26.—and the index is up 5.1% from that September 26 low to the October 17 close. (The Shanghai index has trailed Hong Kong's Hang Seng Index, which is up 11.9% from its low on September 5 through October 17.)

China's markets have turned on anticipation—or hope—of more aggressive stimulus measures from the Beijing government in the run–up to and the days after the official transfer of power to a new leadership team on November 8 at the 18th Party Congress.

But that stimulus could be less aggressive than expected, or it could be ineffective. (For more on why this stimulus could be way less effective than the last round, see my column "The World's Next Big Stock Rally.")

And it's quite possible that the 7.4% growth rate for the third quarter, announced on October 18, doesn't mark the bottom for China's growth in this cycle.

So we don't know, and won't know until we see numbers for growth from the fourth quarter (sometime in the first quarter of 2013) or from the first quarter (sometime in the second quarter of 2013).

If the current stimulus hopes ultimately end in disappointment, I think we'll see a rally on hope that continues the current move up until the disappointing data arrives late in the fourth quarter or early in 2013.

If the stimulus hopes become a real turn in China's economy, and the third quarter of 2012 does turn out to be the bottom for China's economic growth rate, then I think we could see a more restrained version (and slow growth in Europe, China's biggest trading partner) of the traditional explosive rally in Shanghai and Hong Kong.

Even if that rally is restrained, it will be worth owning a piece of it. (This, by the way, is my current read. The third–quarter numbers showed a decided pickup in growth in September, the last month of the quarter.)

How to Read China Stocks
Here's the challenge: China's stocks are notoriously volatile and frighteningly opaque. Many investors are rightly afraid that any Chinese stock they buy will turn out to be a fraud based on creative accounting.

Certainly there have been enough examples of that—Sino–Forest (SNOFF) and Longtop Financial Technologies come to mind. And even if the company ultimately turns out not to be a fraud, a short–selling attack on a Chinese company stands a good chance of success because so many Chinese companies are opaque and hard to understand.

In response to that truth about the Chinese market, and in order to derive an investing strategy responsive to the unknown potential of what looks to me to be the early stages of a significant rally, I've come to think of China's stocks in two groups: "bad" and "good."

Usually when investors talk about "good" and "bad" stocks, the "good" stocks are those that they'd buy and the "bad" ones are those that they'd shun. Here I mean something slightly different.

"Bad" China stocks are those that you don't want to buy on their fundamentals—because the fundamentals could be deceptive, misleading, or downright fraudulent, and frequently an investor has no hope of knowing the truth. Oddly enough, in the Chinese markets, I think these "bad" stocks are frequently those that do best in the early, explosive stages of an anticipation rally like the one that seems to be building now.

"Good" China stocks are those that give investors more certainty that the fundamentals are indeed as advertised—even if we still can't be entirely certain. These stocks can lag in the early stages of an anticipation rally. But as anticipation of growth turns into real growth, you'd much rather be in this group than holding the early "bad" rockets.

The usefulness of this strategy lies in being able to tell the difference between "good" and "bad" and being able to match that difference to the appropriate stage of the market. You may choose not to own "bad" China stocks even during the early stages of a rally—they are volatile and risky, although that goes along with their tendency to outperform early in the cycle.

But you still should learn to recognize the difference, even if it's only so you don't get sucked into buying that "bad" stock when the early owners are starting to sell.

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So What's a 'Good' Stock?
"Good" China stocks share a number of characteristics in their business models and in their financial statements. For example, they often pay dividends.

Why is that important? Not because these companies pay a mouthwatering yield. Most dividends in the Chinese market are quite modest. But it's worth buying dividend–paying stocks in China's markets because it's relatively hard to fake a dividend payout. The check either arrives or it doesn't.

A company that pays a dividend is probably generating cash (although in financial history, you can certainly find companies that were borrowing money in order to pay a dividend). So a Chinese stock paying a dividend is more likely to be making a profit and showing positive cash flow. Think of a dividend payout as a proof of concept for the stock.

So I'd put Guangdong Investment (which trades as 270.HK in Hong Kong) in my "good" stocks category, because it pays a 2.95% dividend. That cash comes from the company's cash flow as Hong Kong's water utility.

If management ever significantly botched its other business—the company is a major property developer—so that the utility cash flow wasn't sufficient to cover the dividend, there's a good likelihood that it would manifest itself in a lower dividend that would be apparent to investors. (Note that the company also trades as an ADR in the US, GGDVY, which pays 2.28%.)

Cafe de Coral (331.HK in Hong Kong) gets points for its dividend yield—2.82%—and the double–check that yield provides on the company's operations and financials.

The 40–year–old company is the largest fast–food restaurant company in Hong Kong, with 320 restaurants (including Spaghetti House and Super Super Congee and Noodles) in Hong Kong and an additional 278 overseas. Sales for the fiscal year that ended in March climbed 12%, while profit of HK$474 million ($61 million) fell by 8% due to higher costs.

The company's final dividend payout of HK$45 a share, a 74.6% payout ratio, is a good double–check on those numbers. For example, the dividend has been rising in the past few years, which is good. But the percentage of earnings paid out via that dividend—the payout ratio—has been climbing, too, from 67.7% in fiscal 2010 to 74.6% in fiscal 2012.

That's bad, since at 74.6%, an investor is entitled to wonder how long the company can afford to continue that payout. (Note that the company also trades in the US as CFCGF, which pays 2.91%.)

I'd call Cafe de Coral a good China stock for reasons that go beyond its dividend payout, however. It gets points from me as a good China stock because its business is relatively visible—if the company wasn't making sales, its restaurants would be empty—and because it's not a terribly complicated business.

An investor can track commodity costs, read about labor costs, and check out price trends by looking at its menus online or dropping by one of its restaurants. (Cafe de Coral operates the Manchu Wok chain in the United States, so you don't even need to fly to Hong Kong.)

The company's business is one that we all are familiar with and understand. That makes it relatively harder to fake results than if Cafe de Coral ran a wind power company where sales could be subsidized by local governments—great until the subsidies run out—or where customers are themselves complicated entities that may or may not be actually consuming what they buy.

(Please, let me be clear: China is not the only country to have known stock–market fraud, and management around the world is amazingly inventive at discovering ways to hoodwink investors. One of my favorite stories is that of famed company rescue artist Q.T. Wiles, who "turned around" disk drive maker MiniScribe in the 1980s by, among other things, shipping bricks packaged as disk drives. Sales, according to the company's books, climbed to $603 million in 1988 from $115 million in 1985.)

Another "good" China stock on this basis is Home Inns & Hotels Management (HMIN). It's pretty easy to count guests at the company's motels, and claims of 100% occupancy, as the company reported at some motels during the recent peak travel Golden Week holiday, are relatively easy to debunk.

And as with Cafe de Coral, because Home Inns & Hotels runs a mass consumer business, the company can't move the revenue needle by booking one or two or a dozen big sales.

The fact that a Chinese company has done a deal with a well–known and, in theory, savvy Western company doesn't, by itself, turn it into a "good" stock. Sophisticated Western investors have been taken for a ride in China, just as in the 19th century sophisticated English investors were hoodwinked by US robber barons who bought railroads and then sold a river of shares until investors were left with nothing but worthless, watered–down stock.

But I'd still say that a foreign deal or two tells you something about a company and its stock. For example, Home Inns & Hotels Management acquired the Motel 168 chain from Morgan Stanley (MS) in a 2011 deal that was partly financed by JPMorgan Chase (JPM) and Credit Suisse (CS).

Investors know that Morgan Stanley, JPMorgan Chase and Credit Suisse all did due diligence on Home Inns & Hotels—although we can't know how good that due diligence was.

Sometimes a "good" stock characteristic is overwhelmingly strong. In other cases, a stock gives you a list of "good" stock characteristics, but each one individually is relatively weak.

For example, Ping An Insurance (PNGAY) does pay a dividend—but it's just 0.79%—and it does have "sophisticated" Western investors such as HSBC (HBC), even if Western banks have a mixed history in their investments in Chinese financial companies.

Recognizing the 'Bad'
"Bad" China stocks are often simply the reverse image of "good" ones.

For example, I'd put companies such as China Eastern Airlines (CEA) in the "bad" group, because its major financial relationship isn't with a Western bank, but instead with a state–owned parent company that recently provided a big infusion of cash into what I'd call a nearly bankrupt airline on amazingly generous terms.

I think any investor would be rightly suspicious that management will continue its pattern of overexpansion leading to near bankruptcy as long as it thinks the parent company will rescue it with government money.

I'd also put a number of industrial companies in the "bad" stocks category if they do business with large state–owned or affiliated customers that may themselves be motivated by something other than market efficiency.

For example, local Chinese governments have been buying steel from steel producers to keep the mills (with their big payrolls) open. Suntech Power (STP) now relies on cash from the Wuxi government to stay in business—even if it can't sell solar panels at a profit.

Aluminum Corp. of China (ACH) was established in 2001 as the flagship of China's aluminum industry. (The company is now the second–largest aluminum producer in the world.) Investors can be certain that acquisitions and decisions about capital spending will be based more on the perceived strategic needs of China than on income–statement profit and loss.

Jiangxi Copper (JIXAY), another state–owned company and the largest copper producer in China, sells to many customers that are themselves state–owned enterprises. Decisions by government officials about how much copper to keep in inventory have more effect on demand at Jiangxi Copper than do global trends in production and consumption.

These same "bad" stock characteristics aren't limited to industrial sectors, however. I'd put Hong Kong Exchanges and Clearing (HKXCY) into the same group.

The company's June purchase of the London Metal Exchange for a very expensive $2.1 billion had more to do, in my opinion, with the Chinese government's strategy of building Hong Kong into the dominant financial center in Asia than with achieving a profit on that investment in any reasonable time frame.

A Time to Own the 'Good' and 'Bad'
In my "good" and "bad" China stock strategy, an investor wouldn't necessarily shy away from "bad" China stocks.

In fact, I think that at an early stage in a potential rally—just about where we are now—you want to own a few "bad" China stocks. At this early stage, some of the characteristics that make these stocks "bad," particularly their close connection to the government, are viewed as advantages by Chinese traders.

My favorites here would include Aluminum Corp. of China and Jiangxi Copper, up 25.3% and 24.4%, respectively, from the bottom on September 5 through the close on Wednesday. I wouldn't worry about these stocks getting too pricey—as long as nothing disrupts the macro picture—until gains from the bottom are 50% or more. If this turns out to be a rally on hope, you do want to sell these shares on any sign of disappointment.

As we accumulate more evidence that the government's stimulus measures are working and that China's growth rate has bottomed, I'd be looking to move to "good" stocks. Here, my favorites are Home Inns & Hotels Management, a member of my Jubak's Picks portfolio, and Ping An Insurance.

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 Guangdong Investment, Home Inns & Hotels Management, Hong Kong Exchanges and Clearing and Ping An Insurance as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio here.

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