Is China Undervalued Right Now?

During the past few years, China has become an increasingly compelling destination for investment capital. But with the recent weakness in the Chinese stock market – and serious cracks showing in the façade of China’s economy – does it make sense to invest in China right now?

One money manager I know thinks so. In fact, he thinks that some of China’s US-listed stocks are trading at low enough valuations to triple in 2010 regardless of how the economic situation unfolds… I’ll introduce him to you in a minute.

There are two parts of the macro backdrop that are important to understand about China. First, there has been a tremendous increase in bank lending since the end of 2008 – it’s up something like fourfold. And we know from experience that when banks grow that fast, bad things tend to happen later. What happens when banks grow that fast is that they slide down the credit-quality spectrum. In short, they make tomorrow’s bad loans.

Secondly, we know that the Chinese government has put in place a huge stimulus plan. And again, we know from experience that when governments invest money, you inevitably wind up with “bridges to nowhere” and all kinds of boondoggles. The money doesn’t flow to its best economic uses, but to political ends.

In Beijing, you can see some tangible effects of this. I recently visited, for instance, the largest mall in Asia. It was built six years ago by state-run enterprises. They put it on the western edge of the city, about 40 minutes from Tiananmen. Real estate people thought it was a bad idea. It was too far away…and too big.

Well, the pros turned out to be right. And today, the place is virtually empty. It was almost eerie walking through there. There were lines of bright shops with neatly dressed attendants and shelves full of the latest products from the world’s best brands. But there were no customers.

This place has over 10,000 free parking spaces. There is over 1.8 million square feet of retail space here – over 167,225 square meters. That’s about three times the base of the Great Pyramid at Giza.

It makes you wonder. Why did this place ever get built? And boy, are they losing their shirts. But then you wonder about the shops themselves. Why do they stay? How can they possibly make money here? It’s all very strange.

But then you go 30 minutes into town and visit another big mall packed with people. The parking lot is so full you have to wait to get in. When one car leaves, they let one in.

The residential property market also feels bubbly – a lot of construction going on despite widespread tales of empty apartment buildings. One rationale we heard from people here is that the Chinese view property as a store of wealth. We heard stories of how people buy brand-new apartments and don’t even attempt to rent them out. They just hold onto them.

Interestingly, besides property, the Chinese also like gold as a store of wealth. China is the world’s largest consumer of gold (and its largest producer), only recently passing India. So if there is a property burst, gold should be a winner. In fact, while I was here, CCTV News – China’s big television network – reported that China is seeing a surge in gold buying recently as people here start to get nervous about a potential property bubble.

As you can see, China’s economic picture is complex – as it is everywhere, really. The US economic picture is equally murky and uncertain.

However, in some ways, you don’t have to figure it all out. I met with a money manager here – a low-key guy whom I cannot name. Yet his fund is up over 1,000% in 10 years. He knows the China market as well as anyone. He was short the market – that is, he was betting it would fall – as late as January, but he is now buying again.

As he told us, there are some Chinese stocks that are also listed in the US that trade at very low multiples of earnings. Some of them, when you net out the cash, trade for as little as 3 times earnings. As he says, you don’t really need to have a positive view on China to buy these.

When asked about the China bubble, he told me. “I don’t really care. I know I can buy some stocks that could well double in six months, regardless.”

Though even here, the market is tricky. You really have to know what you are doing. There are bad auditors and shady accounting practices here, as in the US. And there can be big gaps in quality between certain names. It’s a market for which it helps to know people on the ground who know the quality of the management teams.

Chris Mayer
for The Daily Reckoning