Chinese Small Caps Still Look Good

11/09/2010 9:35 am EST


James Oberweis

President, Oberweis Asset Management, Inc.

James Oberweis, editor of the Oberweis Report, says that after five years of investing in small Chinese stocks, he’s still finding attractive bargains, and he names three of them.

Five years ago, we presented a strong case for investing in China. While Chinese equities have generated much higher returns than US equities over the last five years, it has not always been a smooth ride. Right or wrong, China’s place in the global investment community seems to rotate from hero to villain and back again.

When we began in China, the nascent market for small-cap companies was relatively untapped. We bought undiscovered small caps with no institutional coverage, high growth rates (often greater than 50%) and single-digit P/Es. These days, some of those same dynamics exist, though perhaps not to the same degree.

China’s [gross domestic product] has grown at a double-digit rate annually over the past five years. Earnings at our portfolio holdings have grown even faster. However, the global stock market drop of 2008 pushed valuations to extremely depressed levels, and they have not yet fully rebounded, even though the “disaster fears” that caused stock prices to decline never materialized in China.

Risk aversion among American investors remains quite high, particularly for Chinese equities, yet fundamentals at our portfolio companies in China appear quite favorable. Are there reasons for concern in China? Yes, but there always have been. The typical concerns, highlighted repeatedly by the media, revolve around the potential for nonperforming bank loans, a potential property bubble, expected yuan appreciation, and the risk associated with China’s communist government.

Each of these issues has some merit, but generally, we believe these concerns are overblown when closely analyzed in relation to valuations presently afforded to Chinese equities. Even with China’s risks, we firmly believe that China is better positioned for growth than most other countries.

We believe (as we have for the last five years) that we are in the middle of a long-term wealth shift from Europe and North America into Asia, and China in particular. Rising Chinese wealth is likely to continue to drive substantial GDP growth in China and lead to increasing disposable income for Chinese consumers. Growth-rate disparities between the United States and China will, over time, force the Chinese government to permit gradual yuan appreciation to avoid unintended asset bubbles and inflation.

In the near term, [the Federal Reserve’s announced] second round of quantitative easing (QE) will likely have a side effect—a drop in the value of the dollar. If the yuan is not permitted to appreciate against the dollar, this implies a drop in the value of the yuan (and all other currencies pegged to the dollar) against the euro as well. We believe this would drive demand for emerging market equities and Chinese stocks in particular.

Either corporate profits in China will grow even faster than expected, or, more likely, China will be forced to permit the yuan to appreciate against the dollar to avoid overheating. Either way, owners of Chinese equities win (at least in US dollar terms).

Budget hotel chain Home Inns & Hotel Management (Nasdaq: HMIN) is a play on growing travel by the middle class in China. AsiaInfo-Linkage (Nasdaq: ASIA), a company that sells billing software for telecom companies, and Longtop Financial Technologies (NYSE: LFT), which develops software for banks, both address developing IT needs for Chinese companies.

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