A Value Investor's Dream

In 2006, the Shanghai Composite index rose 130%. Its follow-up performance in 2007? The index nearly doubled.

China was the growth story you couldn't get away from.

With Chinese stocks down 47% so far this year and blowups in other markets (like our own) stealing the front pages, the constant clamor of news about hot Chinese stocks has diminished. But wasn't China the can't-miss growth story of the century? Surely everything didn't go down the toilet in six months, did it?

The economy, inflation, and bears
Peter Lynch is famous for saying that if you spend 13 minutes thinking about the economy, you've wasted 10 minutes. I think that's about right, but to understand how Chinese companies went from incredible growth and momentum stories to potential value plays requires spending a little time looking at China's economy.

China posted 10.1% GDP growth in the second quarter -- still an enviable growth rate for most countries, but the slowest reported since 2005. Inflation, which has dropped from almost 9% to 7%, is still uncomfortably high. To contain inflation, the government has been slowly allowing the yuan to rise, and that move has created fear that China's exporters will suffer.

Does this mean the China growth story over?
Nope. But it does explain why the momentum investors that couldn't get enough of China a year ago are suddenly silent. They want a cheery consensus, but the economic picture is more uncertain than it was just a year ago. High rates of inflation and slowing growth, only if temporary and still ridiculously strong, spoil the party.

A quick look at Chinese stocks shows the decline has been across the board. Small-cap growth stories such as E-House (NYSE: EJ  ) , which is down more than 70%, have been hit the hardest. But dependable growth stories and steady cash-flow generators such as China Mobile (NYSE: CHL  ) are down 30% or more, too. Momentum investors' flight has turned China into a value and  incredible growth play.

China has years of growth in front of it
It's silly to pretend that bouts of inflation, excess capacity, and growing inventories aren't problematic. But they're bound happen every few years, when an economy is growing at double-digit rates and largely in an industrialization and building phase. Economic hiccups like these are cyclical, which means they're temporary problems and a part of the longer-term growth cycle.

Check out these examples
China's manufacturing strength has grown its workforce, and it's becoming a country of hungry consumers. Like the rest of us, they want a home, a car, better education for their children, and maybe even some of the niceties for themselves. This desire and growth in incomes has fueled the double-digit sales growth Yum! Brands (NYSE: YUM  ) and Nike (NYSE: NKE  ) are enjoying in China.

Auto sales in China are further proof of the healthy appetite of the Chinese consumer. With 8.8 million autos sold in 2007, China has quickly become the second-largest market in the world for cars. So far this year, China's auto sales are up more than 15%; sales could hit 10 million units this year. Car companies such as General Motors (NYSE: GM  ) and Honda (NYSE: HMC  ) have benefited handsomely from the growth, but the overall effects are muted at these giants, because China is just one of dozens of countries where they make sales. Chinese automakers and auto-parts makers such as China Automotive Systems (Nasdaq: CAAS  ) provide more direct exposure to this booming market.

Auto-sales growth should continue, too, because China continues to spend relentlessly on new highways to link its cities to each other, the suburbs, and their rural periphery. This build-out of roadways has a virtuous cycle that opens up distribution opportunities for additional goods, creates more income, and well ... you get the picture.

Foolish final thoughts
There's plenty of negativity and uncertainty in the market now, but with many Chinese companies having their shares cut in half, the balance of risk and reward is finally tilted more toward reward. Even if China's growth slows, it's still running much more rapidly than the mature U.S. or Western European economies can hope to achieve. And a top priority of the Chinese government is to continue spreading economic growth to as many of its people and cities as it can. That sounds like a recipe for success.

Bill Mann and our Global Gains analysts went to China last month to check the country's prospects with their own eyes and to sit down and grill more than 10 companies on their growth strategies. While in Asia, the team also visited Indonesia, Vietnam, and Singapore. You can read their notes from the trip and learn about the growth prospects yourself by clicking here to try the service free for 30 days.

Nathan Parmelee is a Global Gains analyst. He doesn't own any of the companies mentioned in this article, but he did own a Honda Accord for a few years once and has been known to grab some Taco Bell on long road trips. The Fool has a disclosure policy.

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  • Report this Comment On July 26, 2008, at 9:17 AM, lukematt wrote:

    I've followed the stock E-House (NYSE: EJ) that was mentioned in this article for a few months. However, I have not purchased any shares because I have not yet received satisfactory answers to these questions:

    1. During 2008 Q1, why did E-House take a $42.7 million RMB loan when the company is flush with cash? Even stranger [to me :-) ], why did E-House secure the loan with a $44.1 million USD deposit, which is now listed on their balance sheets as "Restricted cash"?

    2. On February 1, 2008, why did E-House sell 6 million more ADSs when the company was already (somewhat) flush with cash?

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