Entering China the Warren way

When the world's richest man takes a substantial stake in a Chinese company, is now the time to get more involved in A-shares? Guotai Junan thinks so.
It is worth paying attention when the world's richest man ûand arguably one of its most successful investors û does something in your neck of the woods. On Monday, a subsidiary of Warren Buffett's Berkshire Hathaway spent $230 million on a 10% stake in Chinese rechargeable battery manufacturer BYD Company. And with markets around Asia at a low, now could be the right time to enact Buffett's investment philosophy of buying stocks cheap and holding them long.

At least that is what Chinese securities company Guotai Junan suggests in its September A-share strategy report. Published before the announcement of the BYD deal, the report takes note of a US television interview in August where Buffet said that he had made a $500 million bid on ôsomething" in China. Whether Buffet was referring to the BYD investment is not known, since the final deal turned out to be a much smaller, but Guotai Junan argues that the rest of us should be thinking a little like Buffett right now when it comes to the A-share market.

The domestic Chinese stockmarket has been the poorest performer in Asia this year, having fallen just over 60%.

The report splits the Buffett strategy into two parts: finding the right stocks and buying them at the right time. It applies a model designed by Standard & PoorÆs analyst David Braverman, which is supposed to characterise how Buffett filters stocks. It does so using six criteria: market value above $500 million; free cash flow of over $50 million; a net sales profit margin of over 15% in the past 12 months; a return-on-equity of at least 15% in the latest quarter and the past three years; the growth in market value must be faster than the growth in undistributed profit (although this is modified slightly for the A-share market); and the current share price must be lower than the discounted cash flow for the next five years.

When Guotai Junan applies this to China's A-shares, there are 12 stocks that fit the first five requirements. These include Lu Thai Textile Company, Qinghai Salt Lake Potash Company, and Shenzhen Chiwan Wharf. When the sixth requirement is applied û a current share price below the discounted cash flow for the next five years û only Jinan Iron and Steel Company remains. Time will tell whether the steelmaker is a good buy, but one thing is already clear û it is a lot cheaper than it was a year ago. It last traded at Rmb7.19, which marks a 73% drop from its high in October last year, and translates into a price-to-earnings ratio of 7.04.

Having filtered out the desirable stock, the next question is whether now is the right time to buy. Guotai Junan notes that the A-share market is at a historical low and says that for "rational" investors, the time to be "greedy" is approaching. The report says that not only is the A-share market now undervalued, but profit forecasts are almost unchanged. "We retain our judgement that there will be opportunities from error-correction in 4Q08. Panic is no longer necessary. Now is the time to determine the right stocks to take," says the report.

The idea is supported by one Shanghai-based European investor. "Now is a very exciting time to be part of the China market. Now is a good time to get in if you are a long-term investor, even if [the A-share market] still might look like one of the most expensive markets in the region."

Another investor questions, however, whether you really want to hold for the long term in China. "In a market like China, it is much more difficult to hold over the long term. There are always going to be times when it will be difficult not to sell because the price will have risen so much. And since the market is so volatile, you will be able to get into the market again quickly."
¬ Haymarket Media Limited. All rights reserved.
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