Buy Low ... Now?

Buy Low … Now?

   Is now the time to get into beaten-down Chinese stocks to cash in on China’s shining long-term economic growth? Yes – with some substantial qualifications.

   “Yes” because Chinese stocks available in Hong Kong and the U.S. are truly beaten down. From a high in October 2007 to late August, Hong Kong’s index for Chinese enterprises, the HSCEI, plummeted a breathtaking 44.5%. And China’s long-term economic prospects still stand out. Now there are worries about inflation and overheating (a perennial issue). Longer run, export-driven growth may slip due to rising labor costs. But there is ample room for growth in domestic consumption, especially with China’s mountainous personal savings stash and foreign exchange reserves. Benefits from recent economic reforms are still building, and increased reforms will spur growth even more.

   Putting, say, 5% to 10% of your portfolio is a good way to add punch to your investment. Risks are relatively high, but buying when prices are low dials down risks and increases potential rewards.

   So, are prices low now? A number of Hong Kong brokerages say we’re there, or very close. Dao Heng Securities noted that in the last three downturns, the HSI bottomed out at an average P/E ratio of 12.3. Meanwhile, large Chinese companies have joined the index, slightly altering its character. Dao Heng said it adjusted its calculations accordingly: “(W)e have assumed the benchmark index to reach bottom at historical PE of 11.5X, translating into a target of 20,000 in the worst scenario.”

   Tai Fook Securities also looks to history for guidance, but from a different perspective. The last Hong Kong bull run started in 2004 after P/E ratios rose due to pessimism about earnings at the same time that P/B multiples had fallen, the brokerage said in its August report on market strategy. The relationship between P/E and P/B ratios is now comparable to the 2004 level, Tai Fook said. The firm stated: “We believe attractive bargain hunting opportunities have emerged.”

   However, an analyst for a big U.S. investment company said that in this case, history is not a good guide because of the addition of giant Chinese companies to the HSI. “(Y)ou cannot really come to any useful conclusion whether the index itself has bottomed out by comparing it with history,” Ray Prasad, senior portfolio manager – Emerging Markets at  Batterymarch Financial Management, told me in an email. Prospects for an HSI rally are also dampened by problems HSBC (15% of the index) is having due to the U.S. credit crisis, he said. In addition, he noted that big Chinese oil companies are not fully benefitting from oil price rises because of government price controls on their product.

   Yes, Prasad said, the Hong Kong market is more attractive now because of the sharp decline from highs of last October. But he said earnings per share expectations are “on the higher side…. This should be a head wind for some of the names especially in export and capital goods sectors.” Overall, he said, “An oversold bounce can be expected but the valuations for the Hong Kong market are not attractive enough relative to the other Asian Markets.”

   Batterymarch, which handles accounts for institutional investors such as giant Calpers,  has the considerable resources needed to compare emerging markets. It crunches a vast array of data to rate companies from around the world.

   Even some Hong Kong observers warn about the danger of even further declines in the market. Dao Heng said in its July report that stocks were technically oversold, but it expected the HSI to drop in August and September because of expected disappointing corporate earnings and a slowdown in the global economy. The brokerage’s August report stated: “We take a neutral-to-negative stance on the stock market and expect the Hang Seng Index to reach 20,500 within the next three months.”

   As always, investors must be selective. Batterymarch likes banks, food and agriculture companies and some coal stocks. “Their growth prospects are fairly insulated against the backdrop of a slowing economy and (they) are very attractively valued viz the market,” Prasad said.

 What does it all mean?

*If – like Batterymarch -- you already have a fair amount of your portfolio in Chinese companies and have a good handle on prospects of other emerging markets, now may not be the time to increase your holdings. Sophisticated investors: not now.

*If you focus on short-term results don’t go overboard on Chinese counters. Short-term traders: Be careful.

*If you have little or no exposure to China; want part of your portfolio to give you a shot at high long-term gains; don’t have the expertise or time to follow a range of emerging markets, then yes as long as you are selective. Certainly there’s always the possibility that a weak market could fall farther, maybe much farther. But timing market highs and lows is notoriously difficult even for pros. Now is a good time for small-to-medium retail investors to add some Chinese exposure. Just be sure that when euphoria once again grips this volatile market to sell high. Average investors: yes, selectively.