The Dow Jones Industrial Average (INDEXDJX:.DJI) shed 0.9%, a little more than the Hang Seng Index (INDEXHANGSENG:.HSI) which fell 0.4% for the month. Both indices are in the black for the year, a major difference from the Shanghai Composite Index (SHA:000001) and the China ADR index.
Key stocks in this newsletter are A-Power (NASDAQ:APWR), RINO Int. (NASDAQ:RINO) and Baidu.com Inc. (NASDAQ:BIDU) among NASDAQ listed China stocks. NYSE listings are Noah Education (NYSE:NED), China's second largest mobile carrier China Unicom (NYSE:CHU), and Vanceinfo Technologies (NYSE:VIT) besides the largest Chinese airliner by fleet size, China South Air (NYSE:ZNH).
The fall in Shanghai was the most dramatic and had the strongest driver: fear of monetary tightening. While growth of western economies has been next to non-existent, economies in South-East Asia have enjoyed solid growth with an accelerating pace in 2010. Australia, South Korea, India, Indonesia, and China have all started to increase interest rates, a trend that is not going to change soon. China’s accelerating manufacturing data and strong GDP growth suggests the economy can withstand higher interest rates, a scenario most market participants expect. While China’s currency is pegged to the dollar, it can’t keep a closed eye on rising interest rates in the region. Higher interest rates are not good for equity markets, something sensible investors have started to prepare for.
Another scenario is that some of those South-Asian economies might overheat even temporarily, like India or Indonesia where inflation has been the highest YTD, spurring investors back to safe havens like the U.S. dollar. In this case expectations that emerging market assets are bulletproof investments might prove wrong, throwing a monkey wrench into calculations. One thing is for sure: nothing is for sure in Asia at this point.
The same is true for Europe. Ireland’s debt crisis sent shockwaves throughout the Euro zone, intensifying fears that Portugal and Spain may be next. The $122 billion rescue package proved to be insufficient at first albeit investors calmed down as sound economic news from China and the U.S. stole the headlines. Nevertheless borrowing cost for Portugal and Spain remains relatively high, making these countries primary targets for international funds that may bet on their default. A falling euro means stronger dollar, another negative development for equity markets. Higher dollar prices push commodity and oil prices lower, pushing both index heavyweight sectors in the pits.
But risk is not limited to any geographical location. Besides Asia and Europe, America has problems of its own. U.S. financial stocks carry a lot of risk going forward thanks to unclear bookkeeping of toxic assets. Bank of America (NYSE:BOA) has been hit the hardest lately with no clear indication that the crisis is over. Another potential mine that mainstream media hasn’t caught up yet is the fallout from the expiration of unemployed benefits. Not only will that drag consumer sentiment remarkably lower but it will put a lid on spending, one of the largest forces of the U.S. economy.
We don’t want to sound all gloom and doom because we're all well aware of a lot of positive developments lately. To cherry pick a few: China’s better-than-expected manufacturing activity; confidence that the euro zone will contain the current crisis to Ireland; and U.S. spending before the Holidays were robust besides record number of private jobs creation in November. Altogether there has been an increasing evidence that the U.S. economy, and that the world economy for that matter, has been growing. Yet it wasn’t enough to dent into high unemployment yet. And that measure is key in regaining investors’ confidence that the recovery is sustainable.
Before that happens, investors have to refocus on corporate data to find lucrative investment opportunities.
Looking at third quarter financial reports from China, one thing is for sure: while China may grow fast, it doesn’t mean that investors can pick any industry or company and expect a handsome return.
One of the latest shockers is A-Power Energy Generation Systems (NASDAQ:APWR). If anything, this company looked well positioned to capture China’s insatiable appetite for renewable energy. The company didn’t put all eggs in one basket. It operates the largest wind turbine factory in China with access to advanced technologies from GE, Germany’s Fuhrlander and Denmark's Norwin. It also has entered the solar fray earlier in the year and just recently won four contracts to develop hydropower facilities in Jilin province.
Yet, the company reported sales far inferior to expectations and swung to a quarterly loss! A downgrade from Oppenheimer came too late to shield investors from a 25% dip.
An even worse development took place with Rino International (NASDAQ:RINO). This high volume, quality presumed stock collapsed in a matter of weeks as allegations that it cooked books surfaced. One class action suit followed another, effectively halting trading of the company. While many China stock investors like us hope that whatever misconduct the company may or may not have done will prove untrue, the spectacular fall of the company is a painful reminder that investing does involve risk.
Besides cherry picking a selected few companies, it is always wise to find a common measure for all Chinese companies and then select darlings from the dogs. To do that, we developed the following method. We draw the high-low price range YTD for each and every China stock plus the latest price, measured in a logarithmic scale for comparative reasons on the left vertical axis. Then we calculated P/E for each stock on the right axis and sorted the stock universe by this measure. Then we looked at the most expensive ones, e.g. stocks with the highest P/E and compared it to their current stock price relative to their price range.
As the following chart suggests, Baidu.com Inc. (NASDAQ:BIDU) boosts the highest P/E among all Chinese stocks. BIDU is followed by Noah Education Holding (NYSE:NED), China Unicom (NYSE:CHU) and Vanceinfo Technologies (NYSE:VIT). But here is the trick. Lining up P/E next to the trading range, investors get a chance to see what the market is thinking of a company vs. what financials suggest.
The case for Baidu.com (NASDAQ:BIDU) is straight forward: the stock is trading at high valuation and is trading at the high end of its trading range for the year, because it is one of the best companies out there. Current situation implies that BIDU is a good buy should market sentiment remain strong. The company is expected to deliver robust financials going forward and its stock price to go higher as a result, a viable assumption.
The situation is totally different for Noah Education Holdings (NYSE:NED). The stock is trading at a high P/E because its earnings are next to nothing. Investors sold off the stock sending it to year lows. This is another straight forward story.
China Unicom (NYSE:CHU) is an important find from the list for the following reason: the stock is overpriced. High P/E is a result of weak earnings yet the stock is trading at a hefty valuation. None of the other major telcos are on the high P/E list, suggesting China’s second largest mobile carrier is trading at a premium for no apparent reason.
Vanceinfo Technologies (NYSE:VIT) is a very interesting story, similar to that of Baidu.com (NASDAQ:BIDU). The company has been delivering robust revenue and earnings growth yet is trading at a discount relative to Baidu.com (NASDAQ:BIDU). As long as market sentiment remains at least neutral, chances are that the stock price of Vanceinfo Technologies (NYSE:VIT) is going to go higher.
Identifying the basic scenarios will help investors find stocks for their own liking.
Investors can find another set of stocks, stocks with undeveloped potential, by looking at the lower end of the P/E scale.
China Southern Airlines (NYSE:ZNH) is among the cheapest stocks, yet it is trading at the high end of its trading range. This implies that despite trading at the high end of the range for the year, robust earnings justify additional upside.