Cut through the unprecedented uncertainty Chinese stocks face.
Chinese stocks have had a disastrous summer. The KraneShares CSI China Internet ETF (ticker: KWEB) has fallen 20% over the past three months, is down 29% year to date and has slumped nearly 50% from its 52-week highs. That’s a sharp contrast to the U.S. stock market indexes, which have spent the year setting all-time highs. The reason for China’s meltdown is clear: an unexpected government crackdown on key sectors. Recently, the Chinese government instituted a number of measures to regulate various industries such as for-profit education, online gaming, e-commerce and tobacco. This week, famed investor George Soros wrote in a Wall Street Journal commentary: “Pouring billions of dollars into China now is a tragic mistake.” While Soros warns that foreign investors may be in for a “rude awakening” in China, with discretion there are still opportunities for bold investors. With that in mind, here are four Chinese stocks to buy and four to stay away from.
Chinese stocks to avoid: Alibaba Group Holding Ltd. (BABA)
Alibaba is the focal point of the current bull versus bear debate on Chinese stocks. On the one hand, Alibaba looks like a one-stop way to get exposure to the Chinese economy. Alibaba is the leader in Chinese e-commerce and a key player in cloud computing, payments and other emerging technology areas. It also has equity investments in a wide array of growing Chinese companies. So what is the problem? Chinese regulators are cracking down on Alibaba from all sides. Short sellers have repeatedly questioned the company’s accounting. Alibaba’s charismatic founder, Jack Ma, has disappeared from the public spotlight. And now Alibaba is having to donate many billions of dollars to a social contribution fund to help ease regulatory pressure. Alibaba stock looks cheap on paper, but it’s no discount considering the political storm bearing down on it.
Chinese stocks to buy: China Eastern Airlines Corp. Ltd. (CEA)
A key feature of the controversy with Chinese stocks centers around variable interest entities. Chinese companies technically can’t sell stock overseas. They can get around this by creating Cayman Islands-based entities that hold a claim on an economic interest in the underlying company in China. However, foreign investors now fear that this structure may break down. One way to minimize this risk is to buy state-owned enterprises. These are Chinese companies where the government holds a majority stake. China Eastern Airlines, for example, is 62% owned by the government, giving it a good likelihood of avoiding crippling regulatory action. Also, CEA stock remains depressed due to COVID-19 and the ongoing disruption of the airline industry. However, as the world economy reopens, China Eastern Airlines could come roaring back. And, in any case, it should steer clear of the regulatory drama that has grounded the Chinese internet stocks.
Chinese stocks to avoid: Didi Global Inc. (DIDI)
Didi Global has aimed to become the Uber Technologies Inc. (UBER) of China. Offering ride sharing services, Didi seemed like a surefire winner. The company had topped foreign competition to capture a huge chunk of the market and was set to turn into a cash flow machine in coming years. Didi launched its IPO at $14 in July. Within weeks, however, the dream turned to a nightmare. China’s government announced that Didi’s application had to be removed from the app stores due to privacy violations. Additionally, Chinese government officials stationed themselves in Didi’s corporate offices to oversee the company. Investors still haven’t given up. The stock has dropped from $14 only to the $9s. That’s arguably not nearly far enough given the firm’s existential crisis. The Chinese for-profit education firms have dropped 90% on news that the government outlawed their business model. Didi is simply too dangerous to hold at this point, given the similar wipe-out risk.
Chinese stocks to buy: Baidu (BIDU)
While Alibaba is the most popular Chinese tech stock, Baidu is arguably the most obvious buy-the-dip candidate. Baidu is China’s leading search engine, holding a comparable market position to Alphabet Inc.’s (GOOG, GOOGL) Google in the U.S. market. Like Google, Baidu has branched out into numerous other businesses. Baidu’s other leading operations include artificial intelligence, cloud computing and self-driving vehicles. Baidu has been incredibly successful over the past decade. It has grown revenues nearly tenfold and more than tripled its profits over that span. Yet the stock price has been essentially flat since 2011. This makes BIDU stock look downright cheap; shares are trading at just 9 times trailing earnings. Even if regulators limit Baidu’s profitability, its low starting valuation and broad diversification of the business should protect shareholders.
Chinese stocks to avoid: RLX Technology Inc. (RLX)
RLX Technology is the leader in the Chinese vaping market. The company went public to high hopes in January, with the stock opening trading at $30. Since then, the stock has lost three-quarters of its value. In addition to the general Chinese market malaise, the government specifically issued a new regulatory environment for vaping and alternative tobacco, saying vapes will be treated under the same schedule as cigarettes. This threatens to be a crushing blow for RLX. Altria Group Inc. (MO) stock plunged once the U.S. government put the Juul vaping business in the crosshairs and RLX could face a similar fate in China. Making matters worse, RLX stock isn’t cheap. Even after falling 75%, RLX shares are going for 200 times trailing earnings and are at almost 8 times revenues. That’s simply not enough of a discount for a company in China facing active regulatory scrutiny.
Chinese stocks to buy: China Life Insurance Co. (LFC)
Like China Eastern, China Life Insurance is a state-owned enterprise. This provides substantial protection for foreign investors. In addition, China Life operates as a structurally important enterprise. It is, after all, the largest life insurer in China, and any disruption to it could cause numerous economic dominoes to tumble. As such, the government is far less likely to take shots at a firm like China Life than at independent tech companies. Beyond being a safer investment, what else is there to like about China Life? For one thing, the company is highly profitable. It earned $1.46 and $1.35 per share in 2019 and 2020, respectively. Using the current $9 stock price, that’s a price-earnings ratio below 7. Given China’s demographics, demand for life insurance should remain robust while an improving economic climate could boost returns on the company’s investments. All told, things are looking up for LFC stock heading into 2022.
Chinese stocks to avoid: iQIYI (IQ)
iQIYI aspires to be the Netflix Inc. (NFLX) of China. It is a leading online on-demand video streaming platform carrying originals, Chinese and Korean dramas, anime, and more. Investors were enthused with the concept, and iQIYI’s market cap climbed above $20 billion at one point. However, things have unraveled for the firm this year. China’s government has brought the hammer down on online video games. It will limit youths to playing games for just three hours a week, and it has suspended approvals of new online games altogether. Investors are understandably wondering whether the media clampdown will extend to online video. This comes at a terrible time. iQIYI lost more than a billion dollars in 2017, 2018 and 2019, and then $800 million in 2020. With its growth prospects increasingly uncertain and the current operating business far from reaching profitability, iQIYI stock is a grave risk at this point.
Chinese stocks to buy: Yum China Holdings Inc. (YUMC)
Yum China is a restaurant chain that operates more than 11,000 locations in China. It’s a spin-off of U.S. restaurant group Yum Brands Inc. (YUM) and has the license for those brands in China. Yum China’s most important brands are KFC and Pizza Hut, and it runs Taco Bell in China, in addition to locally grown brands such as Little Sheep and East Dawning. Yum China is an ideal holding in an uncertain period such as this. The company has more than 400,000 employees, giving it a strong reason for the government to permit it to operate normally. As it is, restaurants aren’t a particularly politically sensitive area. In addition, since Yum remains in the picture, it helps provide more transparency for foreign investors. Yum China is selling for less than 30 times forward earnings, and analysts expect the business to grow both the top and bottom lines at a double-digit rate in coming years.
4 Chinese stocks to buy, 4 to avoid:
Chinese stocks to buy:
— China Eastern Airlines Corp. Ltd. (CEA)
— Baidu (BIDU)
— China Life Insurance Co. (LFC)
— Yum China Holdings Inc. (YUMC)
Chinese stocks to avoid:
— Alibaba Group Holding Ltd. (BABA)
— Didi Global Inc. (DIDI)
— RLX Technology Inc. (RLX)
— iQIYI (IQ)
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