Shorting China

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Apr 25, 2010
We're running a posting contest on the Short Screen message boards, and this post was submitted by Short Screen member Hesperian, who is a near-term bear on China:

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Short China! Am I mad? Why would I short such a Brave New World?

Don't call Mustapha Mond on me just yet. I am going short because China's in a bubble. And bubbles...pop!

China's not experiencing just any kind of bubble, but a real estate bubble. I think we've had some experience with that. But not on the scale that only CHINA* can pull off. You've heard of the brand new, totally empty Chinese skyscrapers, have you not? http://www.youtube.com...

*or Dubai

That roaring dragon constructed the world biggest mall: http://www.youtube.com...

Wow! Impressive. Too bad that's empty too.

There are even empty Chinese cities: http://www.youtube.com...

How cute.

Even a LTCM guy, James Rickards, is calling a bubble: http://www.businesswee...

"The Chinese central bank's balance sheet resembles that of a hedge fund buying dollars and short-selling the yuan", said Rickards

The main reason why this bubble hasn't already popped is because the totalitarian Chinese government is propping up the markets. But all that will do is make the landing even harder.

Mark Faber agrees: "There are some symptoms of a bubble building in China, with the increase in foreign exchange reserves, rapidly rising property prices," Faber, the publisher of the Gloom, Boom & Doom report, said in a Bloomberg Television interview today. "From here on, the China economy will slow down regardless. Whether it will crash this year or later, I don't know." http://www.businesswee...

"Some symptoms". Lol. He is being modest. Look at the magic recovery in home prices (scroll about halfway down) here: http://seekingalpha.co...

Hey! I've seen those kind of charts before. On certain OTC stocks. (Disproportionately Chinese OTC stocks, too.)

Faber continues:

"Excessive credit growth in January, and 11.7 percent increase in property prices in one month alone" are "danger signals," Faber said. "The lending rate in China should be at least twice as high as it is now."

A slowdown in China would hurt the Hong Kong property market as well, particularly the luxury segment, he said.

"I'd rather think that with a clampdown, they will have a lot of losses in China, and less funds for Hong Kong," Faber said. "If you have a crash in China property prices, the high- end sector in Hong Kong property will get hit very hard."

Also, we have this:

"The stock of residential properties, developer inventories and land pledged to banks by local governments exceed by three times the nation's gross domestic product. Rental yields in most cities fail to cover depreciation costs. The price-to-income ratio, a measure of housing affordability, is routinely above 20 in major cities, which means an average Chinese citizen would spend his or her entire income for 20 years to buy an average-priced property"

In most countries, that price to income ratio is about 4.

As to be expected, the great American intellectual Thomas Friedman is incredulous: http://www.nytimes.com...

Uninterrupted global growth is such a heart-warming narrative. How could anyone dare suggest a correction might be in order? He ends his article with a condescending remark to Chanos

"Shorting China today? Well, good luck with that, Mr. Chanos. Let us know how it works out for you. "

Oh, but only after he returns the favor to you, you smug twit. It's a good thing you don't put money on your predictions.

There's plenty of additional evidence of a Chinese RE bubble out there, but anyone familiar with a search engine can find it. Now I'm going to talk about why I chose CTRP and HMIN to short. But before I do, one last summary: http://www.businessins...

For starters, if I'm going to short the China bubble, I will want to short the companies most directly tied to the Chinese RE market. There are only so many Chinese companies with high levels of Chinese RE exposure listed in the US. The largest ones are: XIN, HTHT, HMIN, CTC, CRIC CAHS* and EJ.

*joke

Of these, HMIN is the most overvalued, and still in bubble mode, near its highs and trading at a 52 PE. Volume has been slowing, and I doubt it will go much higher. The Chinese RE bubble is being widely whispered about, so it is not completely out of the market's scope of consciousness. And investor worth his salt would be out of his mind to buy this at a much higher valuation.

As a hotel developer/operator, HMIN has obvious exposure to the Real Estate market in China. Yes, it has had strong growth thusfar. However, I think that it will be disproportionately impacted by an economic slowdown due to overbuilding in the Hotel sector specifically ( http://www.investors.c... ), the law of large numbers* (how long can a 1.4B company keep posting the insane growth that justifies a 50+ PE) and that the Chinese government is unlikely to force people to travel in lean times to save the likes of HMIN (but they may positively intervene in other industries). Traveling is a luxury, and it is highly sensitive to any economic downturn.

* "When HMIN was a young company with just a few hotels under management, it was easy to double or triple revenue just by adding a dozen more hotels to the mix. But now that HMIN has reached critical mass, it will be difficult to maintain the growth trajectory simply because of the law of large numbers. The last four quarters have seen revenue grow by 53%, 43%, 38%, and finally 29% in the fourth quarter. That's still impressive growth but not nearly as exciting as the triple digit revenue gains the company used to put up. "

From http://zachstocks.com/...

While reading about HMIN, I came across CTRP, a company that was founded by the same guy. Lo and behold, this stock was in bubble mode also. It is fresh off of new highs and sports a 55 PE. It is a pure travel company highly leveraged to the leisure class, selling things like VIP tickets to nightclubs. With a slope even steeper than HMIN's, it has attracted a number of short sellers (8% short interest) who aren't drinking the China-to-infinity-and-beyond kool-aide. While CTRP doesn't have the direct RE exposure that HMIN has, I think it acts like a highly-levered proxy for the real Chinese economy. When times are good, it absolutely soars. When times are bad, it will plunge. Keep in mind that the business it is in does not have especially high barriers to entry. In fact, on of CTRP's competitors, LONG, might end up on the short block also.

The risk of shorting companies like HMIN and CTRP is that on an individual level, they show few signs of stress. They are not debt laden, and may well be the leading companies in their markets after the impending Chinese bust. But stocks do not have to be unprofitable, debt laden companies to be worth shorting. They just have to be overvalued in an unsustainable revenue stream. Remember Crox?

The line of reasoning that lead to me choosing these companies to short is as follows:

1. China is nearing the end of a massive RE bubble.

2. This bubble will curtail growth for at least the Real Estate (epicenter) and Luxury (no bailouts for you!) markets when it pops.

3. HMIN and CTRP are severely overvalued in light of the macroeconomic situation, even compared to their peers. Their valuation is unsustainable and will cause their stock prices to decline significantly.