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 past 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 almost 30 times earnings! If I'm going to almost 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. They're 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 looks like a promising opportunity. It operates online role-playing games in China, where not only are those games extremely popular, but the Internet is also 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 in October, 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 it still trades for eight times sales and 18 times earnings. That's expensive, considering that this is a competitive space, 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 for an example of what can happen when a company butts heads with the Chinese government, look at how Google is thinking about leaving the market altogether, ceding that huge opportunity to Baidu.com (NASDAQ:BIDU) -- long a government-favored enterprise. Suffice it to say that 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 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, 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. Furthermore, 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).
Short idea No. 3: BYD
Before you say it, yes I know it's not the conventional move to bet opposite Warren Buffett and Berkshire Hathaway (NYSE:BRK-A). But while BYD is the same great company it was when Berkshire announced its original $230 million investment, the valuation is now ridiculous.
How much would a 10% stake now cost you? A cool $1.9 billion, or 31 times EBITDA!
At the end of the day BYD is a good company. It's run a good battery business over the years, competing with Sony (NYSE:SNE) and other large players by selling a high-quality, low-cost product. And while it does have a significant growth opportunity in the electric-car space, which is what Berkshire liked about it in the first place, big automakers such as Ford (NYSE:F) and Toyota (NYSE:TM) aren't exactly ignoring this growth niche. They stand to be good competitors. Plus, at 31 times EBITDA, the stock is just too darned expensive.
Wait a minute
Now that I've given 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.
This article was first published Nov. 13, 2009. It has been updated.
Tim Hanson is co-advisor of Global Gains. He owns shares of Berkshire Hathaway. Berkshire Hathaway is a Motley Fool Inside Value recommendation. Baidu, Google, and NetEase.com are Rule Breakers selections. Berkshire Hathaway and Ford are Stock Advisor picks. The Fool owns shares of Berkshire Hathaway. The Fool's disclosure policy tries and it tries and it tries.
