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China Is a Land of Opportunities

China Is a Land of Opportunities

Investors can’t help themselves. They seem to have emotional responses to everything. Successful investors ignore their emotions and hunt for data. That can be difficult to do but it is important to move beyond emotion and conventional wisdom to find trading opportunities.

One subject that creates emotions among many investors is China. This is especially true for conservative, or less aggressive, investors. These investors tend to focus on risk and they sometimes allow themselves to miss seeing potential rewards. In China, there are no shortages of risks.

One concern for investors in Chinese companies is accounting. In the US, we believe companies follow generally accepted accounting principles (GAAP) and the result is honest and directly comparable to other companies. The concern is companies based in China may not be as scrupulous.

This concern was recently highlight in a series of news articles. Reuters noted, “China’s obsession with economic growth encourages officials and bankers to wink at lending based on non-existent collateral. The problem is vast, but the system is designed to look the other way. What it’s not designed to do is cope with the crisis that could ensue if asset prices fall.”

A Reuters Special Report detailed that loans are often backed by fake assets or by assets already pledged as collateral to other lenders. The special report found that officials are aware of the issue. But, officials and bankers don’t believe this problem will lead to a crisis.

Concerns about fake data extends to government data. Skeptics about the veracity of data from China point to GDP data. The chart below shows the year over year changes in the seasonally adjusted official GDP number.

Skeptics point to the fact that the GDP numbers consistently hit the government targets. This was true even in the midst of the global recession in 2008 and 2009. The New York Times has reported on the issue and their investigation was inconclusive.

Trusting Growth, for the Short Term

While questions exist about Chinese accounting standards and economic data, it is important to remember the stock consists of millions of investors all working with the same information. For the short term, it doesn’t matter if the numbers are accurate. What matters is that they are available.

While fraud is rare in the United States and other developed markets, companies frequently restate their financials. Government data is revised multiple times. This doesn’t make the data bad to use. As long as all investors have the same data at the same time, the market can price in the information.

In the case of China, where risks may be higher, it can be useful to verify the information. This will allow even the least aggressive investors to benefit from trading opportunities.

One opportunity to consider is in Baozun Inc. (Nasdaq: BZUN).

Baozun is a brand e-commerce solutions company based in Shanghai. The company provides end-to-end e-commerce solutions, including the sales of apparel, home and electronic products, online store design and setup, visual merchandising and marketing, online store operations, customer services, warehousing and order fulfillment.

Its segments include the brand e-commerce segment, which provides brand-e-commerce solutions to its brand partners, including IT services, store operations, digital marketing, customer services, warehousing and fulfillment, and the Maikefeng segment that operates its retail online platform, Maikefeng.

China is a relatively closed market and Baozun is growing market share. This can be seen in the stock price. The chart below shows the price action since the company began trading in May 2015.

Financial Statements Show Growth

The company’s financial statements show steady growth in sales. Over the past three years, growth has averaged 30.6% a year. This is similar to the 30.5% growth seen in the past twelve months. Earnings per share (EPS) has grown an average of 37.5% over the past three years.

When a company is defrauding shareholders, the financial statements usually offer some clues. One of those clues would be cash flow. A strong company should report growth in cash flow. For BZUN, growth in cash flow has averaged 40.5% over the past three years.

Cash flow from operations has also been growing, and has been positive in each of the past two years. This is another sign of strength.

BZUN is classified as being in the computer services industry. Its profit margins, liquidity and debt ratios are all better than average for its industry, Return on equity is below average but improving. These are also indicators of financial strength.

With the financial statements showing growth, the stock appears to provide a trading opportunity. To determine the direction of the opportunity, the news should be considered. BZUN is expected to announce earnings in early August and that sets up the trade.

Turning to History to Identify a Trade

Once we know news is coming, it is possible to determine how the stock has reacted to news in the past. In this case, we know that BZUN has declined, on average, after releasing earnings. In the past, the stock lost an average of 3.7% in the week after earnings are released.

To trade a potential decline in the stock, a trader could buy a put. For BZUN, puts are expensive. This is expected since traders know the stock often pulls back after announcing earnings. A put option expiring on August 18 with an exercise price of $30 is trading at about $1.50. This put will be profitable if BZUN declines by about 12.8%.

The high price of the put option suggests an alternative strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility. In this case, with a bearish outlook, a call option should be sold.

Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.

One strategy that is important to consider is the bear call spread. This trade uses two calls with the same expiration date but different exercise prices. Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call, so this strategy will always generate a credit when it is opened.

The risk profile of this trade from The Options Industry Council web site is shown below.

The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.

The maximum potential gain with this strategy is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received.

A Bear Call Spread in BZUN

For BZUN, we could sell an August 18 $30 call for about $4.30 and buy an August 18 $35 call for about $1.80. This trade generates a credit of $250, which is the difference in the amount of premium for the call that is sold and the call that is bought multiplied by 100 since each contract covers 100 shares.

The maximum risk on the trade is $2,500. The risk is found by subtracting the difference in the strike prices ($500) and then subtracting the premium received ($250).

This trade offers a return of about 10% for a holding period of about 3 weeks. This is a significant return on the amount of money at risk. This trade benefits if BZUN is below $30 when the options expire.

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