Should You Short These Stocks?

Thanks to the Chinese government's June announcement that it will not pursue a policy of "exchange rate flexibility," it's now no secret that China's currency stands to strengthen over time. This represents an enormous challenge for Chinese manufacturers, whose cost advantage over competitors -- already under pressure because of rising labor and land costs in China -- has long been subsidized by an artificially weak currency. Many, such as Foxconn, have responded by moving operations away from coastal manufacturing centers such as Shenzhen to China's interior, where labor costs are lower. Yet this is nothing more than a stopgap.

When it comes to investing successfully, one key is to identify companies with a durable competitive advantage. Chinese manufacturers are clear beneficiaries of a fleeting comparative advantage. Knowing that, it's easy to understand why we avoid companies like this at Motley Fool Global Gains. But with so many pressures facing China's manufacturing sector at present, the question is: Is avoiding enough? Should we actually actively be shorting the sector?

Candidates for that ignominious honor
Here are five Chinese manufacturers for your consideration:

Data from Capital IQ.
EV = enterprise value. EBITDA = earnings before interest, taxes, depreciation, and amortization.

At a glance, none look horribly overpriced, which is to be expected, since the looming troubles for China's manufacturing sector are no secret. But if you believe China's currency could appreciate 25% to 50%, then business at these companies will drop precipitously. That could make it worth shorting them at any price.

Aye, there's the rub
While the consensus is that China's currency will strengthen, and that it's natural value is closer to 5 RMB to the dollar (versus today's 6.8 RMB to the dollar), there is a question about timing. Manufacturers we spoke to during our recent trip to China, for example, noted that they don't expect the government to let the currency appreciate more than 1% to 2% per year. At that rate, it would take some 15 years for the RMB:USD exchange rate to reach 5-to-1.

While I believe that's insufficient, given China's goals to encourage consumption, the country must pursue a delicate balancing act. If it lets the currency appreciate too fast, it will cause unemployment and unrest; two things the government is not interested in causing. Yet if the government waits 15 years or more, imports such as food and fuel will not become more affordable, and the country's economy will still be fraught with the risk of being too reliant on manufacturing.

So the answer is "avoid"
When it comes to shorting stocks, timing is critical. Even if your thesis is correct, your position can cost you, and you can even get forced out if it takes too long to play out. In the case of Chinese manufacturers, while events are stacked against them, it's unclear when, in what manner, and how fast their businesses will deteriorate. So avoid them for now, but also avoid shorting them.