What Three Chinese Companies Tell Us About The Risks You Need To Watch For In Emerging Markets

May 19, 2017

What Three Chinese Companies Tell Us About The Risks You Need To Watch For In Emerging Markets

  • Proper due diligence is needed to separate low risk from high risk investments.
  • The fact is, nobody does their research anymore as ETFs and index funds have taken over the investment world.
  • I’ll describe a few Chinese investments that look amazing at first but can easily lead to a total loss.

Introduction

Yesterday we talked about how emerging markets are generally becoming attractive. Today we’ll discuss a few Chinese stocks that show some of the risks lying in such a market.

As I see the S&P 500 climb to new highs, I understand that risk isn’t what investors think about, but my experience that spans a few market cycles keeps me focused on the risks while investing.

By risk I don’t mean short term volatility coming from market sentiment. The S&P 500 hasn’t been volatile at all in the last 8 years as it has just gone up, but for every point that it goes up while corporate earnings remain flat, the risk investors are taking gets higher.

My definition of risk is the possibility for permanent loss of capital. This can happen through achieving negative or unsatisfying long term returns from an investment. In simple words, I care about the business, the price I am paying, and the earnings the business delivers in the long term alongside regulatory and country risks. I see volatility as an opportunity to buy more if the fundamentals remain equal.

The main issue with emerging markets is that most investors lack the necessary perseverance to do proper due diligence in order to analyze the risks, especially long term risks coming from changes in the regulatory environment, increased competition, unrealistic growth prospects, or managements’ integrity. Analysts are also focused only on what is profitable, i.e. the S&P 500, so proper buy side and sell side analysis is lacking.

I’ll now discuss a few Chinese companies that look interesting but have risks that could lead to a permanent long term loss of capital. Such investments aren’t for the investor who doesn’t like losing money, but it’s important to understand the risks in order to avoid such investments. However, the stocks could be interesting for the investors with a high-risk appetite.

A Few Chinese Stocks

I’ll start with two stocks that look fundamentally amazing but the regulatory risks make them a high-risk investment.

Yirendai – No Comprehensive Regulatory Framework Yet

Yirendai LTD. (NYSE: YRD) is a peer-to-peer online lending platform. It has a price to earnings (P/E) ratio of 9.1 and had revenue growth of 600% in the last year. Yes, you read correctly, 600%.

Now, a company growing from $2.79 million in revenue in 2013 to $481 million in 2016 looks like an investment you shouldn’t miss. Many investors thought the same thing and the stock quickly grew from an after IPO low of $3.56 in February 2016 to a high of $42.34 in August 2016 only to quickly fall back to the current $24.69.


Figure 1: YRD’s stock has been volatile but this isn’t the main risk. Source: Yahoo Finance.

But the main risk with YRD isn’t volatility, it’s regulatory in nature. Peer-to-peer lending in China just started a few years ago, but companies are constantly introducing new products without knowing what the government’s reaction will be.

For example, YRD has started offering new loan products with different pricing grades. As there isn’t yet a comprehensive regulatory framework for the industry and companies are growing extremely fast, if there is any sign of too much greed, risk taking, or increased subprime lending, the government could easily ban peer-to-peer online lending platforms.

Another example of regulatory risk comes from the fact that YRD acquires 42.5% of their borrowers from CreditEase’s on-the-ground sales network. This practice might be deemed by the PRC regulatory authorities as promoting financing products through offline channels, which is prohibited by the government’s Interim Measures on Administration of Business Activities of Online Lending Information Intermediaries.

I know the growth is stellar and the P/E ratio is low, but such regulatory risks could lead an investor to a total loss. Therefore, only investors that have an investment strategy where a total loss on an investment is accepted due to the diversification of risk in their portfolio should take a deeper look at YRD.

As further support, there are some allegations that 80% of YRD’s loan portfolio is subprime, which could lead to an immediate shutdown of the business if the government realizes what’s going on.

All of the above is enough for me to avoid such an investment as it doesn’t make sense to invest in something just because it’s growing fast and has a low P/E ratio. It is worthwhile to make an investment only if all the criteria of a low risk high reward investment are met. Fortunately, you need only one such investment in a year for your returns to be stellar.

Yintech Investment Holdings – The Government Doesn’t Really Appreciate Speculation

Yintech Investment Holdings (NASDAQ: YIN) is a Chinese commodity trading platform that allowed customers to trade on three exchanges. As of May 6, it only offers trading services on two stock exchanges as the Guandong Precious Metals Exchange stopped offering commodity spot trading.

Given that the Chinese government is sensitive to commodity speculation as commodities are essential for the country’s development, I wouldn’t be surprised if all speculations on commodities is banned from time to time. I don’t know whether such a drastic scenario will ever materialize, but it isn’t a risk that I like to be exposed to with an investment.

YIN’s fundamentals look even better than YRD’s. Its P/E ratio is 5.7, the dividend yield is 6.5%, and the revenue has grown fourfold in the last three years.

Apart from regulatory risks, investors also have to be wary of the main factor determining the risk of an investment, the price paid in relation to the underlying fundamentals.

TAL Education Group

TAL Education Group (NYSE: TAL) provides after school tutoring programs for primary and secondary school students in China through small classes, personalized premium services, and online course offerings. The company has grown by 50% in the last 9 months, its book value has also grown by 40%. Net earnings haven’t grown, but operating income grew 27%.


Figure 2: TAL’s fundamentals are all growing with the exception of net income. Source: Morningstar, compiled by author.

Excellent growth alongside low regulatory risks and a positive environment for additional education in China made TAL’s stock more than quadruple in less than a year.


Figure 3: TAL’s stock performance since IPO. Source: Yahoo Finance.

As the company grew and its stock price went higher, the increased market capitalization forced mindless mutual investment funds to open a position in the company and increase their stake in it creating a self-reinforcing upward cycle. As the market capitalization goes higher, a fund must increase its stake in the company. The result is that Vanguard’s International Growth Investment Fund currently owns 2.46% of the company which makes up 0.86% of the fund’s assets. Even Blackrock has a 1.71% stake in the company.

But do they look at the risks at all? TAL’s P/E ratio is 123 with a net profit margin of 10.3%. In order for the company to justify the P/E ratio and bring it to an average of 15 for emerging markets, earnings have to grow 8-fold. Yes, the company is growing fast, but an 8-fold earnings growth is a very risky path to invest in.

Conclusion

Each of the companies discussed above has several specific risks attached to its business. It’s extremely important to understand the risks before investing as not losing money helps a lot in reaching satisfying returns.

I urge you to clearly understand risks before investing. Thankfully, the investment world is so large now that you don’t have to invest in companies where there is too much risk for uncertain returns.

What’s also important is the fact that leading investment institutions have started to completely disregard risk when investing as all that matters to them is market capitalization. This is bound to end terribly. When the same investment funds are confronted with investors wanting their money back, the forced selling will create amazingly cheap investing opportunities.

The risks described above create a lot of worry and negative sentiment toward emerging markets. But this is investing, understanding the risks of each investment is essential for investment success. As Wall Street usually paints every stock from emerging markets with the same brush, those who carefully analyze each stock in the cheap emerging market environment will find investing gems that will reward them for all the pains coming from temporary volatility.