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 nearly 25 times earnings! If I'm going to pay 25 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: 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 (Nasdaq: CNTF), a cash-eating machine that operates in the competitive and deflationary mobile handset manufacturing market. Just how tough is this business? Even bigger handset makers such as Nokia (NYSE: NOK) and Palm (Nasdaq: PALM) are seeing sales erode despite their cash-rich balance sheets, well-known brands, and global reach.
As for China TechFaith, despite more than $200 million in trailing sales, the company has not had positive free cash flow for more than three years (and has yet to release a cash flow statement for 2009). Further, 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). All of this means that we think Qualcomm (Nasdaq: QCOM) made a smart move selling its shares of this one and that the floor some investors see for the stock at its net cash per share is a false one.
Short idea No. 2: China BAK Battery
China BAK Battery (Nasdaq: CBAK) 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, closing a $20 million offering a few months back. But even that financing 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 two 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. Nokia is a Motley Fool Inside Value selection. The Fool's disclosure policy tries and it tries and it tries.
