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
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
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
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
Short idea No. 3: China BAK Battery
I saved the best for last, of course, and China BAK Battery
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.