Get Into China While You Still Can

"Get out of China while you still can," warned fellow Fool Morgan Housel.

It's cool if you want to bolt. Just make sure you're leaving for the right reasons. If you're in mainland China, overbidding for crappy companies in a manic exchange, I'm with you. Dump the tulip bulbs and run. 

But don't be too quick to judge some of the better companies by their covers, much less their trailing-earnings multiple.

That is where Morgan's argument falls flat. Let's revisit the five stocks he singled out as the best reason to stamp that passport and flee the country. Here's his chart from last week:  

Company

P/E

1-Year Return

China Finance Online (Nasdaq: JRJC  )

629

660%

Baidu.com (Nasdaq: BIDU  )

191

276%

SINA (Nasdaq: SINA  )

70

125%

Sohu.com (Nasdaq: SOHU  )

72

102%

China Unicom (NYSE: CHU  )

67

101%

That's some pretty scary stuff. Is a financial services enabler like China Finance Online really worth a profit multiple in the hundreds? Don't answer right away. You can't judge the road ahead through the rear-view mirror. China Finance Online dramatically upped its guidance last month. A little upside can go a long way when you're producing net profit margins in the 42% to 45% range, as the company expects to do next year.

In short, analysts now expect the company to earn $0.40 a share this year and $0.97 a share come 2008. That's a far cry from the $0.08 and $0.11 marks, respectively, that Wall Street was expecting on the bottom line before the company got rolling.

Does a trailing multiple of 629 seem too high? Sure. If the company hits its profit targets, how does a trailing multiple of around 85 in three months sound? Better. Still too rich for your blood despite the heady growth? How about a forward earnings multiple of just 37 based on next year's forecast?

China may not be cheap, but fat multiples begin to shrink once you narrow your focus on fast-growing companies that are making the most of China's quickly expanding economy.

Building a better table
With Morgan's sky-high multiples in mind, let's look at how each of those five companies is holding up when we tack on what the pros think the companies will earn next year.

2008 EPS est.

Forward P/E

China Finance Online

$0.97

37

Baidu.com

$3.80

92

SINA

$1.44

37

Sohu.com

$1.21

36

China Unicom

$0.95

22

They sure do wash up nicely. Save for Baidu, you can probably pay those multiples stateside on companies that are growing far less quickly than these companies. And since Baidu stands out like a sore thumb, let's use that thumb to hitch a ride to a better bullish argument.

Baidu has a bigger market share in China than Google (Nasdaq: GOOG  ) has in the United States. China's population is four times larger. Google's market cap is 18 times larger than Baidu's.

I'm not suggesting Baidu should command a greater market cap than Google. Big G is a global juggernaut (including its role as a distant silver medalist in China). However, does anyone remember when Google went public three years ago at 90 times trailing earnings? That's pretty much where Baidu is, based on next year's P/E, right? It didn't work out too badly for Google investors who bought in at what seemed like a lofty multiple at the time. I believe that the same will be said about Baidu.

Timing is everything
There may come a time to dump individual Chinese stocks, if not the market in its entirety. But healthy recent gains aren't death sentences. In many cases, the fundamentals are growing even faster than the upticks.

Do you really want to unload your Chinese stocks just two weeks before the Alibaba.com IPO (Yahoo! (Nasdaq: YHOO  ) is snapping up 10% of the shares) and a year before the 2008 Olympic Games in Beijing? Why? Because you don't want to get caught on the sudsy side of a bubble bursting?

Morgan pits Chinese stocks against the dot-com and housing market collapses. It's not a fair comparison. The Internet bubble that popped six years ago was fueled by unrealistic metrics like eyeballs and page views (before Google vindicated the value of traffic). The residential real estate buckle was powered by condo flippers who figured someone would always be willing to buy property no matter how high prices soared.

It's a different kind of mania when you have tangible earnings to lean on. How many bears expect per-capita production, wages, and disposable income in China to fall over the next few years? There's a reason why China is growing at a torrid 10% annual clip.

This does not mean that you should overpay for a growth stock. That's the problem in mainland Chinese exchanges. Thankfully for you, there are plenty of values to be had in attractively priced growth stocks that trade stateside.

You would be wrong to exit from the right Chinese stocks.

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