PEG is calculated by dividing a company's P/E ratio by the estimated growth in earnings per share. For example, a company with a P/E of 10 and forecasted growth in earnings of 20% would have a PEG ratio of 0.5 (10 / 20% = 0.5). A rule of thumb is that any PEG ratio below 1.0 is considered to be a good value.
It’s virtually unheard of to find companies with a PEG ratio of 0.2 or 0.3, but that’s precisely what’s happening with many Chinese stocks. Investors seem not to care that these stocks are cheap. In the eyes of many, they deserve to be cheap. Let’s look at what these companies have done to earn such contempt, then identify ways to close the credibility gap.
For starters, foreign-domiciled companies will always trade at a discount to their domestic peers. The management teams of these companies, either through language barriers or an inability to regularly attend the rubber chicken investor conference circuit, lack the ability to build long-term relationships with mutual fund managers.
In addition, investors are wary of Chinese stocks in general. They question whether the country’s economic miracle can be sustained. The fact that China just announced +50% annual export growth is providing no lift to Chinese shares that trade in the United States.
Investors continue to question whether the country has built too much capacity because we've already seen examples of it happening. For example, roughly 80 Chinese companies began to make glysophate, the generic version of Monsanto’s (NYSE: MON) Roundup herbicide. The industry was quickly flooded with supply, and the corresponding price decline forced 65 of those 80 manufacturers to close their doors. Since most Chinese companies don’t trade in the United States, U.S. investors lack deep insight as to how much capacity truly exists in any industry and they end up expecting the worst.
Finally, investors have also come to doubt that investments in Chinese companies will be protected from equity dilution. In the United States and Europe, companies aim to raise enough money to see them through to profitability. But in China, companies raise just enough money to meet near-term goals. When they need more money, they do another equity offering.
For example, over the last five years, China Security & Surveillance (NYSE: CSR) has gone back to the well again and again. Shares outstanding over the last five years increased from 18 million, to 26 million, to 37 million, to 44 million, and now sit at 51 million. Management can correctly claim that per-share profits -- which have been rising almost every year -- are the real measure. But at some point investors simply want to know that a company can grow without needing a never-ending stream of fresh money.
But as we saw on Thursday morning with shares of A-Power Energy (Nasdaq: APWR), sometimes share prices can be beaten down too far. Shares were too cheap prior to management’s latest guidance, when A-Power boosted its 2010 outlook by a significant margin. Shares quickly posted a +20% gain in Thursday trading, and even though sales and per-share profits are each set to grow in excess of +30% this year, shares still trade for just 7 times management’s 2010 profit guidance.
In a similar vein, Deer Consumer Products (Nasdaq: DEER) just reiterated expectations for robust growth, but continues to be plagued with low P/E and PEG ratios. Shares bounced up +7% on Thursday, but if history is any guide, those gains won’t be sustained. Even a recently announced buyback isn’t doing the trick.
I've put together a list of companies sport ing very low PEG ratios. While one could argue that the PEG ratios for these firms should be slightly below 1.0 to account for the foreign risk discount, some of these valuations seem unreasonably low.
So here’s what these companies need to do to win back investor support:
- Flatly state what their five-year capital requirements are, and let analysts and funds incorporate future share count increases into their earnings models.
- Spend more time with U.S. investors, not just on road-shows with hedge funds and mutual funds, but with the media and investor conferences.
- Take more aggressive steps to unlock shareholder value. If only a few of the companies acted on cheap stock prices by taking themselves private, the rest of the group would benefit from a wake-up call that these shares won’t stay cheap for long.
Action to Take --> Not all Chinese stocks are created equal. Some companies have strong management teams, impressive balance sheets, and robust growth opportunities. I tend to be a fan of Deer Consumer for those reasons, and it's stock buyback plan only makes me like it more. Focusing on the rapidly growing base of Chinese middle class consumers is an underappreciated investing theme. For companies like China Surveillance & Security, keep an eye out for signs that the period of capital-raising is over.
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