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 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 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, which it licenses from Activision Blizzard
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, a cash-eating machine that operates in the competitive and deflationary mobile phone manufacturing market, recently making handsets for China Unicom
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 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 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 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 does not own shares of any company mentioned here. Activision and Disney are Motley Fool Stock Advisor recommendations. Disney is also an Inside Value pick. NetEase.com and Perfect World are Rule Breakers selections. The Fool's disclosure policy tries and it tries and it tries.