Five Ways to Trade a Rebound in China

In May 2015, China was among the hottest stock markets in the world. By the middle of June, the Shanghai Composite Index, a benchmark for stocks traded in China, was up 60% since the beginning of the year. Within a month, the index was down nearly 35%. Within seven months, traders in China had experienced a bubble and a crash.

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  • The 35% decline that began in June was the beginning of a bear market. By February of this year, the Shanghai Composite had lost nearly 50% from its peak and China was one of the least-loved stock markets in the world. Since then, we have seen signs of a bottom forming and the question for investors to consider is whether or not now is the time to buy China.

    The chart shown above meets the classic definition of a crash that follows a bubble. Analysts expect a crash to bring prices down to where they were before the bubble started. In the case of China, as the chart shows, prices in February 2016 were slightly below their January 2015 level. The crash had completely retraced the bubble and from a technical perspective, there is no reason to avoid Chinese stocks as long as fundamental conditions support higher stock prices.

    In China, the government has a large impact on every aspect of life including business. Government stimulus appears to be driving economic growth for now. GDP grew 6.7% in the second quarter, at least in part because of government policies. Among the signs of a supportive policy is the fact that banks lent a record 4.67 trillion yuan ($709 billion) in the first quarter, exceeding the amount of loans made at the depth of the global financial crisis. Reports indicate the pace of lending has remained at record levels in the second quarter with much of the money flowing into infrastructure projects.

    There are concerns that China is building roads and bridges to nowhere, spending wastefully in order to maintain strong employment numbers. Some analysts believe this is unsustainable, but China has the ability to maintain spending at this level for years. With trillions of dollars in official reserve accounts and a budget deficit of just 3% of GDP, China’s government can continue to drive growth. For comparison, the U.S. ran a budget deficit equal to 2.5% of GDP last year. At the other extreme, Greece is running a deficit of 7.2%. China appears to be safely spending on infrastructure for now, boosting employment, economic growth and potentially the stock market.

    The safest way for U.S.-based investors to participate in China’s growth is through ETFs or stocks of Chinese companies that are actively traded on U.S exchanges. ETF investors should consider iShares China Large-Cap (NYSE: FXI). Individual stocks generally offer the potential for better returns than ETFs. We identified five stocks to consider.

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    Noah Holdings Limited (NYSE: NOAH) operates as a wealth management service provider for high net worth individuals and enterprises within the People’s Republic of China, offering a variety of products including fixed income products, asset management plans that are sponsored by mutual fund management or securities companies, real estate funds and collateralized fixed income products sponsored by trust companies.

    NOAH is expected to report earnings per share of $1.74 this year. The average price-to-earnings (P/E) ratio for investment services firms is 18.9, providing a price target of $32.86. EPS are expected to increase to $1.96 next year providing a long-term price target of $37.

    Action to take: NOAH is a buy at $25.10. The initial price target is $32.86. Consider an initial stop at $20.25.

    Alibaba Group Holding Limited (NYSE: BABA) is an online and mobile commerce company offering its products in the People’s Republic of China, as well as internationally. The company operates an online shopping destination called Taobao Marketplace, a third-party platform for brands and retailers; Juhuasuan, a sales and marketing platform for flash sales;, an online wholesale marketplace; Alitrip, an online travel booking platform;, an online wholesale marketplace; and AliExpress, a consumer marketplace. BABA also provides pay-for-performance and display marketing services. Internet access is tightly regulated in China and BABA operates with government authorization. Government regulation provides a barrier to entry by other companies.

    Earnings are expected to grow steadily from $3.18 in the current fiscal year which ends in March 2017 to $4.04 the next year and $5.24 the year after that, an average of more than 25% a year. For growth companies, the PEG ratio can be used to find a price target. This technique assumes a stock is fairly valued when the P/E ratio is equal to the EPS growth rate. For a P/E ratio of 25, based on next year’s estimated earnings, BABA would trade at about $100 a share, a potential gain of almost 20% from the current price.

    Action to take: BABA is a buy at $83.11 or above. The price target is $100. Consider an initial stop at $72.10.

    Yirendai Ltd. (NYSE: YRD) is an online consumer finance marketplace that connects borrowers and investors. In addition, the company also offers investing tools, fraud detection systems and credit scoring primarily to customers within the People’s Republic of China. This is a peer-to-peer lending model and there is demand for small loans in developing markets like China. The peer-to-peer lending model could be the best way to meet this demand.

    There is a limited trading history for YRD which completed its initial public offering at the end of last year. As the chart below shows, the limited history is bullish with the stock moving mostly higher since a steep selloff at the start of the year. Analysts seem to be as bullish as traders. EPS are expected to rise from $1.24 this year to $2.25 next year and $3.44 the year after that. Assuming the growth rate is just half of what analysts expect, the PEG ratio indicates a price target of $31 at 25% growth in EPS.

    Action to take: YRD is a buy at $23.50 or above. The price target is $31. Consider a stop at $17.95.

    CNOOC Ltd (NYSE: CEO) explores for, develops, produces, and sells crude oil, natural gas, and other petroleum products. CEO produces offshore crude oil and natural gas primarily in Bohai, Western South China Sea, Eastern South China Sea, and East China Sea in offshore China; and Asia, Africa, North America, South America, Oceania, and Europe. In 2015, the company had net proved reserves of approximately 4.32 billion barrels-of-oil equivalent.

    CEO’s earnings have slumped with the price of oil. From 2010 to 2014, EPS averaged almost $20 a share. This year, the third year of the bear market in energy prices, analysts expect EPS of about $3.48. Next year, earnings are expected to reach $11.09 with forecasts of $10.54 for 2018. Assigning a market average P/E ratio of 15 to 2018 earnings we have a price target of $158 for CEO.

    Action to take: CEO is a buy at $123.10. Consider a stop loss at $110. The price target is $151.

    JA Solar Holdings Co., Ltd (NASDAQ: JASO), designs, develops, manufactures, and sells solar power products based on crystalline silicon technologies. Its primary products include monocrystalline and multicrystalline solar cells and modules, as well as monocrystalline and multicrystalline silicon wafers; solar product processing services; and solar power plant project construction and development, and electricity generation services. JASO is a China-based company that sells its products to distributors worldwide.

    JASO is expected to report earnings averaging $1.35 in the next two years. This is down from $1.59 last year and the drop in earnings seems to have created selling pressure in the stock. That has led to a buying opportunity in what is now an undervalued stock. With a conservative P/E ratio of just 10 based on next year’s expected earnings, the stock price could gain about 90%.

    Action to take: JASO is a buy at $7.10 and above. Consider a stop at $6.15. The initial price target is $9 where resistance is expected. The long-term target is $13.50.

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