Cashing in on China

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Jim Trippon, editor in chief of the newsletter China Stock Digest, runs the largest equity investment research firm in mainland China and advises corporate pensions, private trusts, and high-net-worth families on their China investment strategies. Trippon spoke with SmallCapInvestor.com’s Jennifer Schonberger Tuesday, sharing his outlook on Chinese small caps and the Chinese economy.

Trippon, who returned to the United States from China earlier this week, is the author of  “Becoming your own China Stock Guru: The ultimate investors guide to profiting from China’s economic boom,” published by John Wiley & Sons, Inc. Part two of Trippon’s interview will appear on SmallCapInvestor.com on Monday.

“I would say there’re two trends that people need to focus on that became real clear on this last trip [to China]. One is that the economic growth is continuing at a breakneck pace. This industrial revolution in China is not a short-term thing. It’s a 30- to 40-year trend … and they have at least another 30 years to go before it’s all done.

“The second thing that struck me on this trip was how inflation is hitting China hard — much higher than what we typically see in the media in the United States. This is dramatically different than what I saw just three months ago because I go to China six months a year. [Everyone’s] cost of living is going up 10% to 15% a year. [Most businesses are] giving out major salary increases to make sure [people] don’t get hurt. The other side of that coin is that although [inflation is] a huge issue in China right now, it’s going to be a huge issue for us in the United States before we know it, not only because of the declining dollar, but because most of our consumer products today are made in China. 

“I would think they would increase interest rates, but there’s only so much the central government can do to control an economy — and we’re seeing this with our own economy. Once you let the free market take hold in a free economy — as ours has done for a long time and as theirs has done more recently — what happens, to a large extent, is going to be dictated by market factors more so than government policy. China has tried very, very hard for the last 10 years (when their economic growth rate has been 8% to12%) to control the growth of inflation. I noticed from this last trip that at this point they’re not able to control it anymore.

“As investors, for us that means that we have more inflation here in the United States and that may affect what U.S. stocks you buy that may be beneficiaries of inflation rather than victims of it. It also affects what Chinese stocks we want to buy for our small-cap portfolios — which plays into my recommendations.

“The banking companies of China would be beneficiaries of [an inflationary] environment in which they could charge more for their loans and could still get their deposits at a fairly low cost. In China there are three places you can put your money: the bank, real estate or the stock market. Real estate is not liquid and the stock market hasn’t been the best place to be over the past six months, so banks are taking in huge deposits and pay out a fairly low interest rate on them, but are charging a decent rate on their loans, so I think [banks] will be big beneficiaries.

“We like commodities, technology and agricultural stocks right now. Commodities are a play on the inflation that’s going on in China right now. If you own the producer of the commodity, and they’re going to get better prices for their commodity if they can control their costs, then as long as their costs aren’t rising as fast as their revenues from the value of the sale of the commodity, they’re going to be a beneficiary.

“In the technology space, as China’s middle class proliferates, what do they buy? They buy cell phones and they buy computers and you’re seeing that happen all over China. Things that play into those industries make sense.

“China Direct (AMEX:CDS) is an investment banker that makes loans to Chinese industries that have a shortage of working capital because their banking sector is not good at providing working capital to mid-size companies. They pick up a stock interest in the companies, and if they like the company they’ll try to pick up a majority stake in it. China Direct started investing heavily in magnesium and is making tremendous progress, basically taking over the magnesium industry in China. Magnesium is an alloy that makes cars lighter and is used in virtually every cell phone. It’s a high-strength, low-weight metal. The reason auto manufacturers want it is to lower the weight of cars and retain their strength or structural integrity, [which would result in] less gasoline [consumed] than [heavier] cars.

“They produce magnesium at an extremely low cost using a byproduct called coal gas — a less energy-efficient form of natural gas — that results from a process of extracting high-quality coal used to make steel. As inflation occurs in China and people pay $3 or $4 per gallon of gasoline in the United States, it’s going to play directly into the back pocket of a company like China Direct, which is manufacturing a product at rock bottom prices.

“China Security & Surveillance Tech (NYSE:CSR) develops software and technology applications that are used by first responders in China. It’s used by the police force, ambulance force and fire department. For example, let’s say you’re walking down the street in some city in Southern China and some thug tries to steal your purse. You call 911 on your cell phone. In China they immediately triangulate your location, tie it in with cameras on street lights and track the offender down the street in the closest police car. They can also identify which ambulance or hospital is closest to your location and can easily send a first responder to help you so that in case you’re injured, you get the medical treatment when you need it as quickly as possible.

“As the population of China continues to shift from the rural areas to 60% in the urban areas from the current 40%, and doubles to 80% from 40% over the next 30 years, they’re very well-positioned to profit from it.

“[Additionally], there is a big “illegal immigration” problem in China from the rural areas into the urban areas because people are seeking economic opportunity in the urban areas. In China they don’t allow you to move whenever you feel like it because they want to ensure that they have room for you to live in the urban areas, so [the government] makes you get a permit to relocate. China Security & Surveillance has a monopoly on the ID cards they use in Southern China to identify when someone is relocating legally or illegally.

“China Agritech (OTC:CAGC) is primarily involved in fertilizers and other things to increase production and productivity of the farm lands. I think as the demographic shift occurs [from the rural areas to the urban areas], they have a good opportunity to profit off that. If you look at [the company’s] most recently published financial results, they had EPS of $0.40. The stock is trading right now at $2.65, so arguably you’re buying it for roughly seven times earnings.

“Now [remember] Chinese stocks are subject to the whims of Wall Street. If the headline on The Wall Street Journal tomorrow is that [a large investment bank] has gone bankrupt, then there’s going to be a pullback in the U.S. markets and a pullback in the Chinese market. That’s the way it is. But if you’re in it for the long haul, it’s a totally different story. If you have a time horizon of three to five years and you don’t mind a little bit of turbulence, I think you’re going to make a heck of a lot of money.

“When the volatility got high last summer we went to 85% cash. We don’t believe in the buy-and-hold routine. We buy low, we sell high and if the market starts going against us, we go to cash. That’s what allowed us to have such strong returns last year. We didn’t go roundtrip and allow [stock prices] to come back down to our purchase price. We sold at our profit and we held on to our cash. If the volatility bothers you, you have to be willing to pull the trigger and have a reasonable stop loss. The key in China is to study your stocks well enough to know where that stop loss should be set. If you use the traditional Investors Business Daily 7% stop loss, then you’re going to get stopped out every time and you’re going to lose your tail. But if you take the time to study the charts and learn more about the trading patterns of the stock, you can set stop losses that will work and will protect you in a total market melt down. What you don’t want to do is get stopped off on normal volatility.

“I think you’ll see a [rebound] by the end of the year. We’re talking about factors in the United States that have impacted global markets. I think to a large degree it’s because there is this linkage, or correlation, between what happens on Wall Street and what happens in global markets. We saw the meltdown in the United States starting last September and October, which was the same time China started their big pull back. I think as we get closer to the presidential election, people will stop focusing on the problems that we have now and start looking toward a change. Human nature is such that people tend to be somewhat optimistic as change approaches. You’ve got historic levels of cash in money markets right now and as we are going into a new administration I think that human nature of optimism is going to be such that you will see money come out of money market accounts and go back into equities. When that happens, the U.S. market will recover and global markets will recover in tandem.

“Have we seen the bottom in the Chinese market? I don’t think you’ve seen the bottom for the domestic exchanges of China. There is a total disconnect between share prices for equities in mainland China and share prices for equities that are traded outside of the country. 

“People have got to invest through ADRs or the Hong Kong shares. It’s valuation. If you look at the companies we can buy here in the United States — the blue chip companies of China that trade in U.S. markets — they often trade at price-to-earnings multiples of less than 20. If you were to buy the same companies that trade in U.S. markets in China, those companies are trading at 10, 12 and 20 times earnings, because there is no derivatives market there, you can’t buy put options and can’t engage in arbitrage. You can buy in China for 50 times earnings, but you’d have to be out of your mind to buy them in China because you can buy the companies here for cheaper. There’s no price advantage of doing so.

“Continued high earnings, continued economic weakness in the United States and the continued erosion of the dollar are going to drive those Chinese stock values. Even if you buy them as ADRs you still have the underlying currency that’s appreciating against ours and that helps our stock price over time.

“Everybody talks about the Olympics. I don’t think it’s going to be that much of an impact. The analogy I would give you is this: we had the Olympics in Atlanta not too long ago. Did that drive the U.S. economy? It probably did for local construction for a short period of time, but what’s the legacy of having the Olympics in Atlanta? I don’t think it solved U.S. economic problems or made a fundamental shift in the U.S. economy. I think what the Olympics will do for China, more than any thing else, is [break the] prejudice of what China really looks like and how modern it has become. It’s the “ah ha” investors get when they realize the economic activity in China is real and that the country’s economy is going in a 180-degree different direction than ours. As an investor, there’s no reason on earth that China should be trading at a lower stock valuation than the United States. They have a growing economy and we have a shrinking economy.  They have a growing currency and we have a shrinking currency. They have a trade surplus and we have a trade deficit. The story of the Olympics isn’t the economic activity that comes with it.”

About the Author
Jim Trippon, editor in chief of the newsletter China Stock Digest, runs the largest equity investment research firm in mainland China and advises corporate pensions, private trusts, and high-net-worth families on their China investment strategies. Trippon is also the author of "Becoming your own China Stock Guru: The ultimate investors guide to profiting from China's economic boom," published by John Wiley & Sons, Inc. Read More

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