Our Top Chinese Consumer Play

When it comes to investing in China, regular readers of this column know that I try to steer Fools away from the popular iShares FTSE/Xinhua 25 Index (NYSE: FXI). There's a reason: Because of the fund's almost 50% exposure to state-run banks and other financials, it's a downright dangerous option. That said, investors in the iShares China ETF have at least one noble intention when it comes to China: They want to be diversified. Given the volatility in the market there and the lack of reliable regulation and oversight, there's simply no other approach that makes sense.

That's why our approach to China at Motley Fool Global Gains is to identify promising themes we want exposure to and then buy a basket of individual companies -- all of which stand on their own investment merits -- to essentially build our own mini ETF. One of the opportunities we identified in the past was our China Rural Boom Basket, a collection of stocks that plays on the fact that growth in western China is faster than that in eastern China given government efforts to increase China's food production on farms and narrow the gap between China's rich and poor. That basket pairs multinationals such as Coca-Cola (NYSE: KO), whose products I found for sale in a shack near the Yellow River in rural Shaanxi province (where the public toilet was just a hole in the ground surrounded by a pile of bricks), with smaller names such as Yongye International (Nasdaq: YONG), whose fast-growing sales of a plant nutrient product are helping farmers grow and sell more food. All told, we like these stocks individually, but we like them even better together, with Coke's relative stability and regular dividend making it easier to bear Yongye's ups and downs.

Yes, you can even find Coke products in this part of China, but you need to bring your own magazine.

But rural China isn't the only part of China we like.

The next basket you should build
Last week's New York Times Magazine reported on another Chinese megatrend that we started to get excited about when we visited China this past summer: the rise of the Chinese consumer. I recommend reading the entire article, but if you don't have time, it basically boils down to this: In order to sustain its economic growth, China needs more domestic consumption.

Since the Chinese government is very much interested in sustaining the country's economic growth (and therefore the Communist Party's total grip on political power), it has already started to undertake measures to encourage Chinese citizens to save less and spend more. These include new national health-care coverage, flexibility to allow its currency, the RMB, to appreciate, and recent subsidies to purchase big-ticket items such as cars and appliances. These are, in many ways, small measures, and China's economic transition will be both long and not without its challenges. But we believe Chinese consumers will grow richer over time and spend increasing amounts of money on both staples and discretionary items.

With that in mind
This is why we've set to building a basket of stocks that will benefit from rising consumer spending and all that entails in China. Among the names we like are multinational YUM! Brands (NYSE: YUM), whose KFC chain is a popular fast-food option in China, and cosmetics company Natural Beauty. And while both of those stocks are up sharply since the summer, our top pick for the basket, a company that will benefit from rising spending by companies on advertising in China, remains a compelling bargain.

That company is China Mass Media (NYSE: CMM). But before I tell you anything else about the company or its market opportunity, you should know this: You can buy the company for less than the cash on its balance sheet. That's right, despite having $103 million in cash and investments, China Mass Media has a market cap today of just $68 million -- giving it an enterprise value of negative $35 million. That would make sense if the cash didn't exist or if China Mass Media were burning through that cash because its business was unprofitable, but neither is the case. The company is audited by the reputable Big Four firm PricewaterhouseCoopers, which has presumably verified its bank statements, and year to date, China Mass Media has earned a little more than $3 million and generated more than $15 million of free cash flow.

Why then is the stock so cheap?

A company in transition
One of the reasons China Mass Media is cheap is because the company has been reselling less and less ad time on state-run China Central Television -- revenues are down from $45 million through the first half of 2009 to just $25 million this year. There is, however, a good reason for this. Because of all of the money that's pouring into the Chinese advertising space (The Economist recently noted that CCTV has already sold $1.9 billion worth of time this year, a 16% year-over-year increase), management at China Mass Media realized they couldn't buy time and resell it profitably. Thus, rather than sacrifice profitability, they opted to focus on a few CCTV shows where they could turn a profit and invest more in building on their creative division, which is actually producing ads for clients in China. This is a small business for the company at present, but it's growing rapidly.

Although China Mass Media's business model is evolving, I like that management is focused on profitability over sales growth (not a trait one encounters often in China) and that management noted in its recent earnings release that it might consider paying a dividend with its strong balance sheet. Further, rising spending on advertising in China should help the company whether it continues to buy and sell time or produce ads for an increasing number of companies looking to advertise to Chinese consumers.

Either way, you're getting a big margin of safety given the balance sheet here, making China Mass Media our top play at present on the Chinese consumer. Remember, though, that the key to investing in China is to stay diversified, so if you choose to invest in China Mass Media, only make it small portion of your overall China allocation.

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