This Rally Can't Continue

Before we get started, you should know that I believe China will be the global economic success story of the next 25 years. That said, the rally across Chinese stocks this year is overdone.

Just as they were before they came crashing down at the end of 2007, Chinese stocks are generally priced today as though there won't be significant volatility in the country's growth story. There will be. Remember, this is a country that's still transitioning from a command-and-control economy, one that doesn't guarantee property rights, and one that doesn't yet have 100% trustworthy accounting regulations or enforcement mechanisms.

Yet the Chinese stocks that trade on our U.S. exchanges today are selling for more than 30 times earnings! If I'm going to pay more than 30 times earnings for anything, I at least want the guarantee that I own it.

You don't necessarily get that in China
The fact of the matter is that many investors love risk right now and are chasing hot returns in the hopes of making up for the losses of 2007 and 2008. That's not a viable long-term investment strategy. In fact, it will only end in disappointment.

So it goes for those suckers. The good news for the rest of us is that we can take advantage of their exuberance to make money. It's with that opportunity in mind that I present to you three China stocks you may consider shorting.

Short idea No. 1: NetEase.com
On its face, NetEase.com (Nasdaq: NTES  ) looks like a promising opportunity. It operates online role-playing games in China, where those games are not only extremely popular, but where the Internet is rapidly penetrating the country's population of 1.3 billion. That's a major market opportunity, no doubt, but NetEase and its foreign shareholders have quietly come under attack from the Chinese government.

It started last month when China's General Administration for Press and Publication (GAPP) proposed a policy that would ban foreigners from having any ownership interest in online gaming in China. And it got worse this month for NetEase when the GAPP said it "might terminate access" to the company's popular World of Warcraft game. Now, one would think NetEase's stock might drop on the news that it could lose a key product. It has, but just barely, and still trades for eight times sales and 20 times earnings. That's expensive, considering that this is a competitive space full of players such as Shanda (Nasdaq: GAME  ) and Changyou.com (Nasdaq: CYOU  ) , and it's very expensive considering the way the Chinese government is contemplating  hurting NetEase.

Of course, the Chinese government may not ever act on this threat; the truth is that no one can know how this will play out. But at Motley Fool Global Gains, we have one rule about investing in China: Never, ever invest opposite the Chinese government.
 
Short idea No. 2: China TechFaith Wireless
Our Global Gains team has met with nearly 100 Chinese company CEOs over the past three years, and many of them share one scary goal: To grow sales as fast as they can, even if they do so at the expense of profits and cash flow. But as Pets.com and all the rest taught us (again!) just 10 years ago, a company is ultimately worthless if it doesn't make any money.

Now apply that lens to China TechFaith Wireless (Nasdaq: CNTF  ) , a cash-eating machine that operates in the competitive and deflationary mobile phone manufacturing market. Despite $200 million in trailing sales, the company has not had positive free cash flow for more than three years. Further, it continues to sell debt and equity to bolster a balance sheet that now has more than $100 million in net cash.

This tells me that management expects to continue to consume cash at a rapid rate, consumption that should be exacerbated by the company's attempted expansion into online games (talk about getting outside your circle of competence). All of this means that we think Qualcomm (Nasdaq: QCOM  ) should be questioning its investment in this stock and that the floor some investors see for the stock at $2.40 (its net cash per share) is a false one.

Short idea No. 3: China BAK Battery
I saved the best for last, of course, and China BAK Battery (Nasdaq: CBAK  ) has just about everything you can hope for in a short idea. It's expensive, it's a commodity business, it's consuming cash, it has a weak balance sheet, and it will likely need to continue issuing shares to stay afloat.

We first profiled China BAK as a short back in June, noting that the company would likely have to issue equity. Well, it did, recently closing a $20 million offering. But while that financing has helped the stock recover, it can't solve China BAK's most fundamental problem: a dramatic lack of cash flow.

This is a bad business in a bad spot, and if you're shorting, you can't ask for much more than that.

Wait a minute
But now that I've give you three solid short ideas, remember what I said at the top: China will be the global economic success story of the next 25 years. That means you want to be invested there for the long term.

And while Chinese stocks are generally expensive today, we've found a few significant pockets of opportunity for our members at Motley Fool Global Gains. To find out what they are, click here to join us as a Global Gains guest free for 30 days.

Tim Hanson is co-advisor of Global Gains. He does not own shares of any company mentioned here. NetEase.com is a Rule Breakers selection. The Fool's disclosure policy tries and it tries and it tries.


Read/Post Comments (14) | Recommend This Article (29)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 13, 2009, at 6:20 PM, SwampBull wrote:

    I like the thinking behind this article, Tim. Even though I don't options trade, I would have to agree that China is over-hyped at the moment. The issue to me will be time frame - if the weak dollar trade continues, and Chinese equities do well as a result, then one might be forced to hold their puts longer than they wanted to. This adds risk because in the condition of high growth for that country, their market as a whole may continue to push upward. Personally I would rather own American companies that sell goods to China. Then again, I work for one such company...

  • Report this Comment On November 13, 2009, at 6:54 PM, Alwayzwrong wrote:

    Are they all selling for 30 times earnings?

  • Report this Comment On November 13, 2009, at 7:24 PM, triciaskeptic wrote:

    Swampbull has it right for now. It will be a while before China stabilizes enough to warrant long-term investment faith. Cautious toe-dipping is in order. U.S. companies that sell to China seem like the best bet. I thinki alternative energy will be taking off big time when oil reaches $90 a barrel.

    Agree?

  • Report this Comment On November 13, 2009, at 8:06 PM, jgrichard wrote:

    Chase capital gsins and you may lose. The rally continues for large dividend investors as it has for the past two years.

    Dividends are not just for the retired when you can make 10% per year.

  • Report this Comment On November 14, 2009, at 4:43 AM, AxIt wrote:

    Frankly, I currently care more about "100% trustworthy accounting regulations" in the west that in China. China will grow in any case for the next decades. And it will grow using its rules (a balanced mix of planned economy and free market), not ours. We may like this or not but that is.

    Regarding valuation, considering the growth potential in the medium term, I think that many ADRs are very good investment opportunities if you can digest short term volatility and have an exit plan for the ones that clearly underperform.

    Yes, I agree, there could be shorting opportunities in the frequent spikes that many ADRs show, expecially after earnings reports. If you are into speculation, thare are many short term profit opportunities in shorting ADRs. But fool is not supposed to be into short term speculation, right?

  • Report this Comment On November 15, 2009, at 10:47 PM, VegasMartin wrote:

    Just take a look at FUQI. Stock ran from $3 to $31 and is now under $20 and falling like a rock even after an INCREDIBLE QUARTER because of decreased guidance.

    http://www.ShootTheBears.com

  • Report this Comment On November 15, 2009, at 10:49 PM, VegasMartin wrote:

    Just take a look at FUQI. The stock went from $3 to $31 and now it's under $20 and falling like a rock despite an INCREDIBLE QUARTER due to decreased guidance.

    http://www.ShootTheBears.com

  • Report this Comment On November 16, 2009, at 1:40 AM, ExitOnBir wrote:

    Vegas - FUQI is a bad example. You forgot to mention that FUQI is now trading at 11 times the earnings estimate. Unless China enters into a deep recession in the next year or two (I guarantee it won't), FUQI is "cheap". FUQI's drop was nothing but a typical Wall Street Raid.

  • Report this Comment On November 16, 2009, at 11:27 AM, xjp83x wrote:

    I'll agree with you on the "this rally can't continue". The DOW is rising too fast.

    However, I also don't think the market will go downwards. I'm sure the trend will eventually look more linear than exponential for the next 2-3 years. Nothing can rise too fast, especially in this economy.

  • Report this Comment On November 16, 2009, at 11:32 AM, Sovestor wrote:

    The 3 short candidates mentioned are not all well-researched. Any prudent investors can and should dig down deeper to NTES and CNTF's financial data and will find very good numbers, growth and prospects which we found. However, we agree with CBAK as being risky. But not for NTES and CNTF. In fact, any pullback on these two stocks is a compelling opportunity to intelligently add positions. These two high growth stocks are still selling at reasonable valuation (NTES on the high side, and CNTF on the low side.) The new gaming business that CNTF is embarking is a good diversification strategy with high upside in our view. Why one would prefer to continue with commodity type business when you still have a chance to go after high margin business with potentially much higher return on investment. In light of this logic, we view CNTF's management decision to go into gaming as a wise capital allocation decision that can propel CNTF forward, grow, aandt the same time change the revenue mix for the better.

    Hence, we project NTES and CNTF are likely to outperform not only any US market indexes but also MSCI Emerging Market Index.

  • Report this Comment On November 16, 2009, at 11:50 AM, Sovestor wrote:

    On CBAK, our view is that the stock will likely be stagnant or slightly declining. We do not think CBAK can decline significantly as Chinese markets keep rising; this positive tide will likely hold the CBAK' stocks demand and supply. However, for NTES and CNTF, the fundamentals are sound. And hence, we consider strongly that the short reasoning for these two companies is baseless.

  • Report this Comment On November 16, 2009, at 1:11 PM, kedo76 wrote:

    Great article. This rally can't continue...unless it does. Great strategy.

  • Report this Comment On November 20, 2009, at 12:47 PM, jesse2159 wrote:

    China still has lot and lots of very serious problems to contend with. They have so much pollution, water issues, air quality and contaminated soil, that it's hard to see how this financial juggernut will suceed in the long haul. The communists have mortgaged ther future, just as the Soviets did in the 1950's. Keep in mind that enviromental problems cannot be solved by new regulations. It takes decades, and often centuries to undo the damage. China has yet to even start the process.

  • Report this Comment On December 01, 2009, at 2:27 AM, eatstocks4fun wrote:

    Take a look at CNTF's latest earnings report. They added 17M of cash and earned .13 eps in operating profits. Revenues and Margins are projected to improve going forward.

    The stock is trading at a significant discount to net tangible assets and now looks technically strong.

    MF's investment thesis has holes.

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