Wednesday, September 7, 2011

Baffled In Beijing

I just returned from a very special trip. My family and I were in China for over 2 weeks helping with some charitable work for two causes very close to our heart. We chronicled our trip, which if you're interested, you can read about it here. Although our charitable work was the primary focus of the trip, I couldn't help but to keep an eye out as to what's happening in China's economy. I noticed a tremendous amount of growth since my last trip in 2003. China is a country that is in a hurry. The building of roads, bridges, airports and buildings continues at a feverish pace. During our visit to 3 "smaller" cities ( populations of 2-3 million each ) Changsha, Datong and Changzhi I saw a total of approximately 125 ( yes, 125 ) high rise condominiums under construction. And, that's only in the areas of those cities I was in. A few of the sales centres indicated that over 90% of the units are unsold - based on the broken English of the sales reps I met in Changzhi. Prices are high and supply is coming on strong. I wouldn't be a buyer of Chinese real estate right now. However, on the flip side, the economy there is big and growing. There is great demand for metals, coal and all things agriculture related (corn, soy and vegetables). There is a growing middle class that want North American products. I noticed several brands that have a good foothold in China including, Coca-Cola, Pepsi, Kraft, GM, VW, Caterpillar, Audi, Starbucks and Kraft (I love the orange/mango oreo's). Owning stock in some of these brands-but not at any price, going forward, is a good way to participate in China's growth without the worry/risk of directly owning Chinese stocks. There is a lot of room for efficiency in the Chinese economy. That will happen over time.

Being in China for a better part of August's major market pull-back was a blessing. Having no CNBC, BNN or North American newspapers insulated me from the overwhelming negative tone. While there are concerns about the economy and issues in Europe, stocks have generally priced those issues in already. There has been significant indiscriminate selling of equities, as evidenced by the record mutual fund redemptions in August. The herd is selling when they should be buying. Several sectors have become very cheap over the summer. These sectors include technology, retail, energy and agriculture (too a lesser extent). Energy is probably the one stand-out sector. Since the market sell-off, oil has come down from $100 in July to $80 at the August lows ( now approaching $90 at time of this post ). This pull-back is minor, considering oil bottomed out at $47/barrel in March of 2009. The market is telling us that demand is still there, and no double-dip recession is on the horizon - contrary to what the headlines indicate. However, oil stocks, particularly the large integrated oils (in U.S. and Europe), have sold off much more. Many of the large European integrated oils have been double-whacked, compounded by the debt crisis in Europe. These European oils are very well capitalized and have access to the cheapest capital in Europe and abroad, so the debt crisis is only a minor irritation to these companies. The market is pricing the European oils as if they will NEVER grow earnings in the future - that's a postion I'm willing to bet against. The following European oils are "pound the table" cheap: British Petroleum (BP), Royal Dutch Shell (RDS-A), Total SA (TOT). These companies are trading at close to book value with hefty ( 5%+) dividend yields and single digit P/E's. While one could argue they do deserve a slightly lower valuation than our large Canadian oils, due to lower reserves (oil in the ground) and production growth, the valuation gap is just to big. On the flip side, one could argue that the European oils deserve equal valuation due to their exposure to emerging markets and experience/success in growing reserves in politically difficult areas like Africa. Which would you buy?

                                                                     P/Book            P/E*         Div Yield

Canadian Natural Resources (CNQ)               1.7x               10x          1.0%
Cenovus (CVE)                                              2.8x                15x         2.3%
Suncor (SU)                                                    1.3x                9x          1.5%

British Petroleum (BP)                                     1.1x                5x           4.6%
Royal Dutch Shell (RDS-A)                             1.2x                7x           5.1%
Total SA (TOT)                                               1.1x                6x           7.0%
* I used forward P/E's, which I don't normally put much weight on. However, using trailing P/E's, which reflects recessionary earnings, gives a false indication on the valuation of these companies.

As I've written in previous posts, it's a good time to pick away at cheap stocks on down days. It's a good time to upgrade your portfolio. Many high quality companies with good dividends are on sale. If you can ignore the daily noise and look 3 years out, the market is cheap, and you will be well rewarded.

Disclosure: I own TOT

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