A Massive Bubble and an Incredible Buying Opportunity

The headline of this article promises that I will reveal two things: A massive bubble and an incredible buying opportunity. Generally, those would have to be two different things. Not today. Today, both are true of China.

The massive bubble
The IPO calendar here in the U.S. has been dominated by Chinese companies in recent months, with 13 companies (and more coming) from the Middle Kingdom having gone public here since October. These IPOs, headlined by the massive recent gains in "YouTube of China" Youku.com (NYSE: YOKU  ) , have generally been a success as investors have bought in to these businesses and their growth opportunities in the world's fastest growing economy. Today, all 13 of those recent IPOs trade at very healthy valuations.

Company

Market Cap

EV/Sales

EV/EBITDA

Youku.com

$4,337

92.9

N/A

E-Commerce China DangDang (NYSE: DANG  )

$1,134

3.6

378.0

China Xiniya Fashion (NYSE: XNY  )

$611

4.7

14.1

Bitauto Holdings

$108

4.9

32.6

Noah Holdings (NYSE: NOAH  )

$922

40.2

107.1

SinoTech Energy

$350

9.2

14.4

Xueda Education

$737

5.1

58.4

Le Gaga

$337

6.9

14.4

Mecox Lane (Nasdaq: MCOX  )

$392

1.9

35.4

TAL Education (NYSE: XRS  )

$1,125

11.6

45.9

ShangPharma

$232

3.1

14.1

Global Education

$199

3.6

16.4

Daqo New Energy

$400

3.5

7.8

 

Average

4.9

24.5

Source: Capital IQ.

Now, if you've read my columns before, then you know that I'm generally bullish on China for the long term. That said, some of the numbers in this table are ridiculous. Not only are these Chinese companies, and therefore carry with them all of the risks of investing in China, but some of them aren't even good Chinese companies. Take Youku.com, for example. Investors are currently valuing the business at more than $4.3 billion despite the fact that the company had just $35 million in revenues through the first nine months of 2010 and lost more than $2 million at the gross profit level. Tack on operating expenses and this $4.3 billion business has lost more than $21 million so far this year.

Even better, owners of Youku.com stock don't even actually own the operating business in China, but rather have "contractual arrangements" with the companies that are actually running this business in China. Good luck getting those contracts enforced by a Chinese court if the real owners ever decided they wanted to be rid of their foreign "shareholders." And what are the prospects for the "YouTube of China" anyway? Well, the real YouTube is reportedly marginally profitable at best despite being one of the world's most popular websites and having the world's best Internet marketer -- cash-rich Google (Nasdaq: GOOG  ) -- standing behind it.

These stocks, in other words, are overvalued.

The incredible buying opportunity
If recently listed small Chinese companies are trading at rich premiums, one might assume that the same is true of small Chinese companies that have been publicly listed for longer. In fact, it might even make sense for them to be valued higher since they have longer public track records.

This, however, is not the case. Due to recent allegations from short sellers that many small Chinese companies can't be trusted, U.S.-listed Chinese stocks today are trading for just 1.2 times sales and 6 times  EBITDA on average. You don't need to be a genius to notice that that's a lot less than the multiples investors are awarding newly listed Chinese companies, implying that the less the market seems to know about a company, the more its willing to pay to own it.

That's stupid, of course. Although these companies are newly listed and, in some cases, have reputable venture backing, I suspect they suffer from many of the same deficiencies that plague Chinese companies writ large: weak internal controls, poor communication skills with outside investors, lower standards of corporate governance, and a preference for size and sales growth over profitability and efficiency. Think I'm wrong? A glance at DangDang's registration statement reveals that it has a dual-class shareholder structure that gives its Chinese owners effective voting control, and Mecox Lane is already subject to several class action lawsuits for allegedly filing an "inaccurate registration statement," and hiding some of the challenges the business was facing from investors.

What to do with this information
Ultimately there has to be a reversion to the mean here. Either the newly listed small Chinese companies will trade down reflect the sentiment of their peer group, the peer group will trade up to reflect newfound optimism about China, or both groups will meet somewhere in the middle. Although some long public small Chinese companies are no doubt troubled and will never make money for investors, some others have been unfairly maligned and are too cheap today. The country is the world's most exciting emerging market and investors -- who pay the right price to own the right companies -- should do well as companies in that market grow to meet its increase consumer, commodity, and infrastructure needs.

But investing in China comes with myriad risks, which makes it imperative to not overpay (and paying more than 92 times sales to own a contractual arrangement with a poorly run website is overpaying). So what should investors do? One clear strategy to profit from the massive valuation discrepancy that exists between old and new small Chinese would be to buy a diversified basket of the old, cheap ones and short a basket of the shiny, new, expensive ones. And while the natural hedge is part of the allure of this trade, fast-forward ahead one year and I'll bet you'll have made money on both sides.

Tim Hanson is co-advisor of Motley Fool Global Gains. He does not own shares of any company mentioned (the only company mentioned potentially worth owning is Google). Google is a Rule Breakers and Inside Value recommendation. The Fool owns shares of Google. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (18) | Recommend This Article (62)

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 December 10, 2010, at 5:35 PM, oldengineer wrote:

    And the incredible buying opportunity is ?

    Is the strategy to buy cheap ones and short expensive ones the incredible buying opportunity?

  • Report this Comment On December 10, 2010, at 6:03 PM, drillerjim101 wrote:

    The headline to this article is misleading.

    Don't waste your time.

  • Report this Comment On December 11, 2010, at 9:21 AM, midnightmoney wrote:

    I found the article a wise and useful warning about a trend I have no perspective on. Beyond that I appreciate the high quality of the writing. As a teacher in Poland I Sometimes use sections of fool articles to teach proficiency students the elusive art of clarity. This is one they'll be seeing a part of. Cheers.

  • Report this Comment On December 11, 2010, at 9:24 AM, midnightmoney wrote:

    Whoops.Hope I'm not breaking any rules by using them...

  • Report this Comment On December 11, 2010, at 1:05 PM, FlyingRiki wrote:

    I'm beginning to wonder about these articles now that I've been reading over several months. Do the Fools vet these guys or just use them to fill space........? I want to hear from the Fools,not a bunch of unknown Bloggers!

  • Report this Comment On December 11, 2010, at 2:13 PM, mikenpdx wrote:

    @FlyingRiki

    the author is a Fool. In fact he is the lead guy for the Motley Fool Global Gains service and I think he is involved with a couple of the other services as well.

    now don't you look silly.

  • Report this Comment On December 11, 2010, at 6:12 PM, sfalk949611 wrote:

    All sounds too risky and even confusing to me.

  • Report this Comment On December 12, 2010, at 1:30 PM, lctycoon wrote:

    There is a backdoor way to get in on commodities growth in China. Rather than buying the Chinese companies themselves, buy American or European companies that export commodities to China.

  • Report this Comment On December 13, 2010, at 11:29 AM, Brent2223 wrote:

    I'm always wary of relative valuations - small caps too expensive, large caps less expensive therefore large caps must be undervalued. I wish anyone investing in China good luck, I myself don't think investing in an opaque communist country using traditional capitalist investing assumptions will end well. Way too far out on my risk/reward chart.

  • Report this Comment On December 13, 2010, at 1:22 PM, SwingStockSurfer wrote:

    A great name that exactly matches the context of the article is Telestone Tech. (TSTC). They have one of the most respected auditors so you are not just buying a story. Fantastic game changing products (and great management. "Telestone developed and commercialized its proprietary third-generation local-access network technology, WFDS(TM) (Wireless Fiber-optic Distribution System), which provides a scalable, multi-access local access network solution for China's three cellular protocols. This technology is currently in trials here in the US. They just retained CCG Investor Relations to design and execute its investor relations campaign.Way undervalued at 12.

  • Report this Comment On December 14, 2010, at 7:02 AM, vslick50 wrote:

    sold all my chineese stocks.they can't be trusted.no tangable assets in north america to hold them accountable.fuqi,rino,china nat gas,rino ect

  • Report this Comment On December 15, 2010, at 7:28 AM, riffdex wrote:

    I got one important thing out of this article. I have been weary about investing in foreign stocks (mainly because I do not know the markets as well) but other reasons too. I would not feel safe leaving in shares I do not own (or, more likely, my broker owned).

  • Report this Comment On December 15, 2010, at 5:15 PM, easyavenue wrote:

    Oh, Tim!

    You keep trying to play both sides of the street in China. First you say "Due to recent allegations from short sellers that many small Chinese companies can't be trusted...."

    Aren't you falsely creating or al least grossly exaggerating these "Short Sellers?" Who, exactly, are these people and what have they said that wasn't true or shouldn't have been questioned publically?

    Then you go on to say "deficiencies that plague Chinese companies writ large: weak internal controls, poor communication skills with outside investors, lower standards of corporate governance, and a preference for size and sales growth over profitability and efficiency." Gee, Tim, it sounds to me like those are the exact reasons I shouldn't own Chinese stocks, the exact things a short seller would say.

    You say "the less the market seems to know about a company, the more its willing to pay to own it" is stupid. But is it really, when the more we learn about most of these small Chinese companies the more problems reveal themselves?

    Realistically, doesn't doing small business in China seem to very often involve graft, cover-ups, lying, cronyism, dual or false bookeeping, you name it? The ethics of getting ahead there simply are much different than here. Right or wrong? Well, in theory anyway (joke about the recent Madoffs, etc. of our business world). Yes, they have a little bit of capitalism taking hold, but isn't the economy still run by communists, for communists? Perhaps you should learn how communists run things? What it really takes for someone in a communist country to get something done?

    One final criticism: you seem heavily weighted and focused on China. Yes, I know you went there. But what about Columbia, Mexico, Turkey and Viet Nam for example? Aren't there solid opportunities in these places, too?

    Sorry if I come off too bitchy. Don't really mean to.

    EA

  • Report this Comment On December 16, 2010, at 4:39 AM, will19699 wrote:

    I think Dang has promise since it has small float and is currently beating out Amazon.cn. Great management too. I am considering buying the dip. Growth is off the charts and they are profitable.

  • Report this Comment On December 17, 2010, at 12:57 PM, Alijac wrote:

    @midnightmoney #3, your comment and the article's content reminded me of a well-known song, the title of which could be re-hashed as 'Elusive Flutterbuy'. It seems many things can be caught unawares with the use of a Net at the end of a stick if all due care's not tak_en garde. Get the point? T'ouch!e.

    Investing in China comes with myriad [read: my'triad', not mine, but I think you get the idea]risks but then what doesn't these days. It can be very dangerous when a market's bull goes silly in a China shopping too! Odds are that it would only break even at beast...err...best!

  • Report this Comment On December 17, 2010, at 1:01 PM, jclams wrote:

    Is this a artcle with useful knowledge, or a shameless, not at all foolish, marketing ploy for a newsletter.. I hope we are not attracting fools to the foolish.

  • Report this Comment On December 19, 2010, at 2:53 PM, rabbittfool wrote:

    The article made sense but what is the small cap Chinese fund you recommend? The article isn't really helpful without this information.

  • Report this Comment On December 23, 2010, at 3:15 AM, gatman1 wrote:

    China is a story of monumental nation building accompanied by the greatest financial/debt bubble in history.

    It will be interesting to see how it all plays out.

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