Speculating in the People's Republic of China

Ryan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Those of us here at the Foolish Blogger network pride ourselves on being investors. We focus on facts, and long term results. We don't get swept up in the latest "hot" issue, and the thought of dancing in and out of the market for quick profits is not appetizing to us. I'm incredibly thankful to k be an investor. Executing dozens, if not hundreds, of trades each and every day has never appealed to me. It's a game that average investors just don't win often enough over the long term.

While I abhor high frequency trading I can't resist speculation from time to time. But when I do, I try to make my speculations as intelligent as possible. I can tell when I am placing my capital into a situation where a satisfactory return is far from assured. In doing so I am speculating. There is nothing evil about speculating it is a lot of fun. It just isn't always  profitable.

The best advice I have for fellow investors thinking about trying their hands at speculation is this: treat it like gambling. Never put more money into a speculative situation than you are comfortable with losing completely. The potential for big profits is incredibly enticing. But we must never forget to realize that along with the potential for massive gains comes potential for crushing losses.

Still that shouldn't stop us from chasing after the 50 and 100 baggers because they do exist in tiny quantities. My speculative search for a massive winner brought me to China. Fraud in the field of stocks is especially problematic here, so much so that Chinese companies ought to be viewed with an eye of suspicion. Here are three of my top speculative picks out of the People's Republic of China.

 Diversified diesel engine maker

The main asset of China Yuchai International Limited (NYSE: CYD) is a 76.4% interest in an entity its reports refer to as Yuchai. Short for Guangxi Yuchai Machinery Company Limited, this partially owned subsidiary is a manufacturer of diesel engines, their parts, as well as diesel generators. On top of that China Yuchai International has a nearly 50% equity investment in a hospitality company with hotels in Shanghai and Malaysia.

This company sells for $665.6 million. I bold that number because as investors, being able to relate what is being offered to what must be paid is an invaluable skill. 

First, some bad news. For that price you would receive a company whose revenues contracted 13.3% from 2012 to 2011, during that same period gross profit margins shrunk .9% to 21.4%. Ouch! Additionally the company's majority shareholder (controlling 34.9%) is also in possession of a "special share" that entitles them to elect a majority of the board of directors, and veto practically any resolutions they find unfavorable.

Shifting focus to the positive: China Yuchai International has $922 million dollars in working capital, or over 100% of its current market cap. It has over $500 million in cash alone. Price to tangible book is below 1, almost always a good sign. Shares currently yield 2.2% with a payout ratio of 36%, steady dividend increases for years to come? I hope so.

How does it compare to the industry leader?

How does China Yuchai International match up with Cummins (NYSE: CMI), king of the diesel engine industry? The superior enterprise is, without a doubt, Cummins. Superior margins and more sustainable earnings power both belong to Cummins. If somebody told me they would give me $1,000 dollars to invest in one of these companies on the condition that I must hold it for at least 20 years, I would, without a doubt, pick Cummins. 

However, while China Yuchai International is more risky, it also has way more potential upside in the shorter term. The price to tangible book ratio for China Yuchai International is .68 vs 3.48 for Cummins. If China Yuchai International can sustain any earnings growth in the next few years I believe, in the short term at least, its shareholders will realize far greater gains than those of Cummins. 

More cash than its market cap

Provided the numbers are legit, Xinyuan Real Estate (NYSE: XIN) is about just as cheap of a stock as you will ever find. Praise the stock screener,  wouldn't have found this one without it.

This real estate developer focuses mainly on residential properties in Chinese cities that are economically prosperous. Although not on the levels of a Beijing or a Shanghai, the cities they are in are economically developed. Making moves in the United States, Xinyuan has snapped up properties in Brooklyn, Reno, and Irvine, California. Getting into the United States real estate market during a time period that is historically cheap is a wise move from this company.

Ah the cheapness: It's wonderful seeing the market offer stocks this cheap, because it proves that it does exist. Xinyuan is sitting on $442 million of cash and their market cap is currently $272.5 million! Its price to tangible book ratio is .37, and it is paying a 4.5% dividend with a 10% payout ratio. That is insanely cheap. I really hope this one isn't fake, so I can pump a ton of money into it.

Final Foolish thoughts

Speculating can be a lot of fun. And it can make you a ton of money, but it is also very risky as well. Recognize when you are speculating. Never put more money in a speculative situation than you can afford to lose with it having no effect on your daily life! Although with these two picks I hardly feel like I am gambling. Yes massive amounts of frauds have come out of China. But excellent companies do emerge.

It takes some courage to invest here for sure, but I believe these two Chinese small cap companies offer insanely cheap potential. In my opinion Xinyuan is the cheaper of two incredibly, awesomely cheap stocks. On the other hand I appreciated how China Yuchai International Limited bolded and italicized risk factors in their financial statements, whereas Xinyuan only italicized. When you assaulted with warnings about how this investment is by no means a guarantee, you usually are being told the truth.

 

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Ryan Palmer has no position in any stocks mentioned. The Motley Fool recommends Cummins. The Motley Fool owns shares of Cummins. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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