May 27, 2014 - Take a Safer Approach to Chinese Stocks
After years of blistering economic expansion, China has started to deal with slowing growth, hitting an 18-month low of 7.4% for the first quarter of 2014. The first quarter figure raises concerns that for the first time in 15 years the country may fail to hits it annual growth target this year, which it set at 7.5%.
In fact, Reuters has forecast economic growth of 7.3% during the year, which would mark the lowest level of economic growth in the last 24 years.
As a result of the rapid economic growth the nation has enjoyed over the last 20 years we are in a situation where conditions in China have a ripple effect across economies around the globe, including here in the U.S. As a result, concerns over the current state of the Chinese economy weigh heavily on Wall Street.
Chinese officials, acknowledging the problems the nation currently faces, have already taken action to help spur the economy moving forward. The nation's central bank recently took steps to loosen mortgage-lending standards with the goal of boosting the nation's real estate market.
China's real estate market has been a major concern as of late; especially in light of a new government report noting a 25% year over year drop in new housing construction in April. Additionally, property sales were down 14.3% and land sales tanked 20.5%.
The reason why there is so much concern of the nation's real estate market is the importance it has in regards to the health of the nation's overall economy, accounting for roughly 10% of its total GDP. As a result, Wall Street paid close attention to the quarterly report from real estate company E-House Holdings Limited (EJ). The company reported its first quarter results on May 20, and not only did it post better than expected numbers, but it also boosted its full year guidance, leading to 12.7% jump in the stock on the day the news was announced.
The company had a great quarter, with earnings of $0.08 doubling Wall Street's estimate, and quarterly revenues jumped 40% year over year to $163.3 million, well above the consensus estimate for $138.7 million. In addition to the better than expected numbers, the company also issued full year revenue guidance in a range of $910 to $930 million, up from its previous forecast range of $880 to $900 million, and better than the $899.6 million analyst forecast.
While the earnings and forecast were enough to give the stock a much-needed boost, the company did issue cautionary statements. It stated that the upbeat numbers come "despite softness in certain cities", which the company expects to persist through the remainder of the year.
Another sector of China's economy that captures a lot of attention is its technology sector, and several big tech companies reported their results as well this past week.
Giant Interactive Group (GA) is a leading online game developer and operator in China. The company reported its first quarter results last week, and failed to live up to expectations for both earnings and revenues. While revenues were weaker than expected, they were up 0.4% on a year over year basis. The improvement in revenues mostly came as a result of several new multi-player games, and move into developing mobile games.
SINA Corporation (SINA), a huge online media company in the nation, has been trending lower in 2014, and continued its downward momentum following its first quarter report. The company posted better than expected earnings, but the company issued weak revenue guidance which resulted in the stock falling to a new 52-week low.
The good news was that SINA's quarterly earnings came in at $0.06 per share, much better than the $0.06 loss analysts had forecast, and that adjusted revenues jumped 38% from the same period last year. While that sounds great at first glance, what drove the stock down to a fresh 52-week low was the company's forecast of revenues during the current quarter in a range of $177.0 to $182.0 million, below the consensus estimate of $183.0 million.
So what can investors take away from the recent headlines involving China? Two things jump out at me.
First, the nation still faces many headwinds. The recent real estate numbers are not pretty, and economic growth could hit its lowest level in 24 years. These facts are reason enough to be cautious over the future of Chinese stocks, but the upbeat report from EJ puts some of the real estate fears to rest.
Secondly, the recent earnings reports offer plenty of reasons to be optimistic in regards in the economy. EJ and GA easily outpaced analyst estimates, and while SINA issued weaker than expected guidance, its quarterly results also came in higher than expected.
Overall, I believe that Chinese stocks will be more stable in future months than they have recently been, but I would advise any trade related to Chinese companies be not only diversified, but also hedged just in case things take a turn for the worse.
Investors looking to play the Chinese economy may want to consider a trade on the iShares China Large-Cap (FXI).
Chart courtesy of stockcharts.com
FXI is an exchange-traded fund that is designed to track the performance of the FTSE China 25 Index, which tracks the largest companies in the Chinese markets available to international investors. As you can see in the above chart, investors have already started to take a more bullish approach to FXI in recent months.
A nice hedged trade on FXI would be the August 30/33 bull put credit spread. To set up this trade, you would sell the August 33 put while buying the same number of August 30 puts for a credit of 20 cents. The trade has a target return of 9.1%, which is 39.0% on an annualized basis (for comparison purposes only). FXI is currently trading at $36.41, so this trade has 8.7% downside protection.