Don't Buy This Buffett Pick

Odds are that if you heard about a Warren Buffett pick trading near its 52-week low that had "amazed" Bill Gates, you'd be pretty interested in picking up shares for yourself. You might even rush out to do so once you got wind of the rumor that Buffett was looking to increase the size of his investment in the company. Tack onto that the fact that it's a fast-growing company in China, and this could be a stock you'd hold and profit from for the next decade or more.

Does this wonder stock exist? Yes, it's Chinese automaker BYD, but BYD bulls are misguided. Investors looking for undervalued stocks or for exposure to China should be looking elsewhere.

Image source: Getty Images.

The case for BYD
Before I get to bashing BYD, it's important to note that Buffett has already made a lot of money on this investment. The 10% stake Buffett bought in the company in 2008 for $230 million after being impressed by company management and its aim to become the world's top seller of electric cars is now worth almost $1.2 billion. That's a good return no matter how you slice it, and it was generated by BYD's fast growth over the past year -- sales and operating income were both up more than 40% -- as well as by the benefits of the spotlight Buffett's investment shone on the company. With China now the world's largest auto market and industry groups estimating 30% growth there this year and beyond, BYD's prospects for maintaining its momentum look on the surface to be fairly good.

BYD, however, has some warts that are beginning to clarify themselves to investors.

The case against BYD
First, the company announced in early October that the Chinese government had repossessed seven of its factories because they were being constructed on illegally rezoned land. Not only does this development inhibit BYD's capacity for near-term growth, but it also shows that the company may not curry as much favor with the Chinese government as might be expected with such a high-profile operator.

Second, the company delivered very disappointing recent earnings, with profits dropping 99% year over year in the most recent quarter. The reasons cited were falling sales in China and delayed shipments of electric cars to the United States. The former reason is of particular concern because China needs to be a near-term growth driver for the company with the widespread adoption of electric cars still seemingly so far off. But BYD is nothing special in China, with its basic offerings competing on price with a bevy of domestic and foreign rivals, including Dongfeng, Geely, GM (NYSE: GM), Ford (NYSE: F), and more. Most concerning for BYD investors is that shipments by competitors GM and Dongfeng increased even as BYD's were declining.

Third, it doesn't look like the headwinds that depressed demand for BYD cars during the third quarter are abating. The Chinese government recently decided to end tax breaks for purchases of small cars, and because of worsening traffic jam problems in Chinese cities, will actually be limiting new car purchases next year (and potentially for the foreseeable future). This is bad news for BYD. With increasing competition and depressed demand, it should prove difficult for BYD to meet the growth expectations that are priced into its stock.

More on those expectations
What are those growth expectations? At first glance, BYD's valuation at 1.8 times sales and 14.1 times EBITDA doesn't look all that appalling within the broader context of China. Recent Chinese offerings such as Youku.com (NYSE: YOKU) and Dangdang (NYSE: DANG) are trading for much higher multiples despite having much lesser businesses.

But place BYD within the context of the automotive sector -- in China or elsewhere -- and it starts to look much less attractive.

Source: Capital IQ, a division of Standard & Poor's.

Sure, BYD trades at a discount to electric car industry peer Tesla, but it trades at a wide premium to other global automakers and a slight premium to its Chinese peers. This might make sense if one concluded that BYD was going to be China's leading automaker or if its battery technology would help it conquer the electric car market, but I suspect neither one of those scenarios to emerge. China, again, is a hypercompetitive auto market already, and the CEOs of Ford, GM, and other major manufacturers have said that China stands to be their No. 1 growth market going forward. Given that GM, via a joint venture, is already China's No. 1 automaker with better than 13% market share, it will be difficult to dislodge.

As for the electric car bet, it strikes me as speculative at best. Not only will it take years for consumers to make the transition (if they ever do), but BYD is not the only company trying to perfect this technology. Again, it's competing with established giants as well as with innovative upstarts such as Tesla.

The global view
All told, if you're looking for exposure to the Chinese auto market, instead of thinking about BYD, think about lower-priced options such as Dongfeng or a multinational such as GM. And if you're looking for exposure to the electric car market, hold off entirely until we get a better handle on how the technology will be deployed.

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