One of the cornerstones of prudent value investing is nonconformity - a contrarian approach that finds appeal in out-of-favor stocks and sectors. We know that this is where the bargains lie. But when we pull the trigger on a new stock against the advice and consensus of others, it's still hard. Howard Marks (Trades, Portfolio) once commented that most of his best investments start with a feeling of discomfort. So with that in mind, I decided to take a fresh look at the global market in search of an unpopular sector offering a considerable margin of safety.
The Chinese spirits industry. If you feel the urge to stop reading after hearing "Chinese stocks," hear me out.
Without an intimate knowledge of a foreign economy, I would never suggest purchasing speculative small caps or second-tier companies of which you have no working knowledge. The three stocks I have identified have market caps between $3 billion and $22 billion USD. These are international titans with global presences and decades of operational history. They are industry leaders that produce and sell quality liquor, wine and spirits. Basically, they're the Chinese versions of Jim Beam and Annheiser Busch (before it was bought).
The three stocks of our focus are Wuliangye Yibin Co. Ltd. (SZSE:000858), Luzhou Lea Jiao Co. Ltd. (SZSE:000568) and Yantai Changyu Pioneer Wine Co. Ltd. (SZSE:000869). And yes, the six-digit numbers are their ticker symbols.
Together, these three firms represent a ¥106.7 billion market capitalization ($17.18 billion USD) and combined annual sales are $12.6 billion. Compare this with global giant Diageo's (DEO) $17.3 billion in sales and the significance is more apparent. But for the additional 37% of sales generated by Diageo, you'll have to pay an additonal 369% for the stock.
But these stocks are not buys based on low price to sales multiples alone. All three have clean balance sheets with zero long-term debt. They are also carrying substantial cash positions representing 33% (SZSE:000858), 27% (SZSE:000568) and 9.2% (SZSE:000869) of their stock prices. It would take both reckless management and severe economic hardship to send any of the three into insolvency.
I also like to check new stocks against the company's historic price to book multiple. Of the powerful GuruFocus value screens, the Top 25 Historical Low P/B Companies have outpaced the indexes by the greatest degree. The model portfolio is up more than 11.25% this year alone. Given this multi-year track record of outperformance, it has become a personal favorite for identifying opportune buys. Its genius lies in the fact that it compares the P/B of high quality stocks against ITSELF instead of an arbitrary metric or industry competitors.
The three charts below show the 10-year price to book history of each of our three Chinese distillers. As you can see, all are being offered at prices unheard of anytime in the last decade.
For those without Global Membership that cannot access Chinese stock metrics, I have also included the valuation headers for each.
As if the rock-bottom discounts weren't enticing enough, each of these companies pays a healthy dividend.
- Wuliangye Yibin Co Ltd (SZSE:000858) 4.11% yield
- Yantai Changyu Pioneer (SZSE:000869) 3.96% yield
- Luzhou Lao Jiao Co Ltd (SZSE:000568) 9.88% yield
These yields blow away the 1.81% average of the S&P 500.
WHY THE DISCOUNT?
Like every out-of-favor industry, there is a reason for the discounted nature of these securities. In our case, the price declines are tied to a political shift in China. President Xi Jinping has led an anticorruption drive designed to reduce excessive spending by both government officials and consultants attempting to woo federal contracts.
At first this did not seem significant enough to cause such a strain on a multi-billion dollar industry. Fortunately for me, I happen to work with GuruFocus founder and Chinese-born investor, Dr. Charlie Tian. He explained it to me like this:
"It is very different in China. Very expensive restaurants, what would be 5-star establishments here, are generally filled with government employees enjoying lavish private parties and several thousand dollar dinners. Government officials make up a much larger percentage of the spending population than they do in the U.S. While most of the lavish entertainment in the U.S. involves corporate executives and celebrities, in China it is mostly people working for the Chinese government."
So to put this in terms better understood by U.S. investors, it is the equivalent of all Fortune 1000 companies suspending their expense accounts and banning executives from expensive restaurants. Essentially a shift is taking place from over-the-top excess to a respectful level of austerity.
Make no mistake, sales are declining. These stocks are not falling based solely on speculative fear. Revenues are down on the year, but nowhere near to the extent of company stock prices. These three stocks are down 52%, 62% and 71% over the past 24 months even though revenue and profits have been effected far less severely. This is an over exaggeration, and Mr. Market is saying, "Stocks are on sale!"
While it is difficult to put an exact dollar amount on the true value of these securities, today's prices are clearly well below the number. In addition to the revaluation that is probably going to occur, these companies are already working on new ways to boost their bottom line. Don't expect them to lie still and take this beating.
According to Peter Evans of the Wall Street Journal, "Consulting firms working in China said they had requests from clients in the spirits industy to help reposition their high-end products to fit in with austerity."
Adam Xu of Shanghai-based consulting firm Booz & Co. echoes these findings: "There is now more of a focus on success than luxury"
Is this a sure thing? Absolutely not. But other than 1% government bonds, what is? This investment does require a small leap of faith - the faith that these industry-leading firms will not sit idly and watch their numbers slide further into the gutter; faith that they will, as many have for 100 years or more, continue to innovate and find creative solutions to temporary setbacks. These companies aren't on suicide watch. None of them are over-leveraged or strapped for cash. They are all financially stable and very much profitable.
Margin of Safety
In addition to the low valuation levels we have already discussed, I chose this small basket of three stocks to add an additional margin of safety. While my savvy Chinese co-worker assures me that all three companies are household names, diversifying this allocation among the three should further isolate the portfolio from catastrophic events. And since wine and spirits have always been a recession-proof business, unfavorable economic conditions are not likely to have a devastating impact.
If you've never invested in China before, this might be a good place to start.
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