No matter what anyone else tells you, low-risk/high-reward opportunities in the stock market are an endangered species these days. That's because there are too many analysts combing over stocks, too many media outlets reporting news in real time, and too many computers and high-frequency traders arbitraging away inefficiencies. So if you want to earn outsized returns in the stock market, the fact is you have to take some risk.
That said, there is such a thing as too much risk.
And here is just such a thing
China Northeast Petroleum
The company revealed in an April 20 filing with the SEC that its financial statements should no longer be considered reliable, that it had been massively misstating net income and the value of its oil reserves, and that it had material weaknesses in internal controls. It's been subsequently alleged that senior officers at the company were embezzling funds.
This, obviously, is unacceptable, and the belief that corrupt and/or incompetent practices such as these are widespread among small Chinese companies is one reason this segment of the market trades so cheaply relative to its market opportunities and growth rate.
The best lies are believable
There are, however, good reasons so many investors wanted to believe in China Northeast Petroleum's story. Above all, the stock looked extraordinarily cheap. This time last year investors saw a company trading for just 2 times EBITDA versus 10 times for PetroChina, 6 for CNOOC
What's more, the broader thesis has turned out to be spot on. PetroChina, CNOOC, and Sinopec are all up over the past year, with CNOOC up nearly 50%. What's more, China's energy fundamentals remain intact, making these larger plays all continue to look attractive. China Northeast, on the other hand, has done nothing but disappoint.
When our Global Gainsteam looked at China Northeast last year, we found a far less intriguing story beneath the surface. My colleague Nathan Parmelee was not only concerned the company was depleting its reserves, but also that its disclosures about its reserves -- the lifeblood for any exploration and production company -- were far inferior to industry comparables.
It wasn't clear exactly what the company was hiding, but it appeared as if it was hiding something. We know now there were significant behind-the-scenes problems.
Issues are everywhere
Yet while we steered clear of China Northeast Petroleum at Global Gains, we have not steered clear of China altogether. In fact, we've recommended that every investor buy a handful of Chinese stocks.
Does that sound crazy? Perhaps it is. Of the five China plays we told investors to buy last July, one has been attacked by short sellers as a fraud and three have made or plan to make seemingly dubious or expensive acquisitions.
Given those facts, you might expect that we've lost a lot of money in China. The truth is just the opposite. Our basket of 5 Chinese plays is up more than 40%, besting the S&P 500 by more than 30 percentage points and the China 25 index by more than 45 percentage points.
As you can surmise, the secret to our success has not been to avoid controversy altogether. Rather, we've embraced controversy as an opportunity to pick up shares in a company that we like for cheap. Instead, our tack has been to broadly diversify across companies and market caps in order to limit our exposure to any single name and instead benefit as China's rising economic tide lifts a larger number of (hopefully seaworthy) boats.
Thus, we've paired Yongye International
While both companies will benefit from China's growing economy and strengthening currency, Yongye obviously has greater growth potential because of its size and focus exclusively on China. It also has the potential to be dangerous.
Coca-Cola, on the other hand, should prove to be far more stable and help us handle the volatility we expect in Yongye's share price. This is how we achieve outsized returns in China without, we believe, assuming outsized risk, and it's the strategy every investor should use to add sometimes dangerous China exposure to his or her portfolio.
Going back for more
It's in order to replicate last year's success that we're heading back to China in July in search of other promising names to add to our China basket. You can join us and get all of our notes from the field simply by entering your email in the box below. To get you ready for the trip, we'll also send a full report on all of last year's picks -- all of which continue to trade at compelling valuations.
Tim Hanson is co-advisor of Motley Fool Global Gains and looks forward to spending another few weeks in China. He owns shares of Yongye, which is a Global Gains recommendation. CNOOC is also a Global Gains pick. Coca-Cola is an Inside Value and Income Investor pick. The Motley Fool owns shares of Yongye and Coke. The Fool's disclosure policy looks forward to having the team buy it a souvenir.