Picking China Stocks By Investing Legends

Was alerted to the insightful and timely article by Windsurfer. This was in the latest issue of Forbes, written by John Reese, who smartly deduced investing legends' investment parameters to come up with stock picks. Below are excerpts from the article on what stocks would O'Neil or Lynch would have picked. His book is worth picking up just to learn what the legends look for and how their minds work, and why.

........... there are a handful of Chinese stocks that appear to be on strong fundamental footing. These are companies that haven't just gotten swept up in the excitement over Chinese stocks; they've also positioned themselves well for continued long-term growth.

Here's a look at some of these top performers.

Petrochina Company Limited: Formed as part of the restructuring of China National Petroleum Corporation in 1999, Petrochina is one of the largest companies in China, with a market cap of almost US$340 billion and annual sales of more than US$100 billion. The Beijing-based business is involved in crude oil and natural gas exploration, transportation, storage and marketing, as well as the production and sale of chemical products and the transmission and sale of natural gas.

Petrochina gets high marks from two of my guru-based models, those that I base on the strategies of Peter Lynch and James O'Shaughnessy. My Lynch-based strategy considers the company a "fast-grower" because of its 24.45% growth rate (based on the average of the three-, four-, and five-year earnings per share figures) --Lynch's favorite type of investment.

For Lynch, the most important variable when looking at stocks was the price-to-earnings-growth ratio, which identifies growth stocks that are selling at a good price by dividing a stock's price-to-earnings ratio by its growth rate. P/E/G ratios below 1.0 are acceptable to my Lynch-based model, with those under 0.5 the best case. When we take Petrochina's P/E (17.69) and divide it by that 24.45% growth rate, we get a P/E/G ratio of 0.72. That's good enough to pass my Lynch-based model's most important test, indicating that this fast-grower is still a good buy.

Lynch also liked stocks that were conservatively financed, and the model I base on his writings calls for stocks to have debt that is no greater than 80% of their equity. Petrochina's debt/equity ratio is 10.99%, passing the test.

While my Lynch-based model considers it a fast-grower, Petrochina also appeals to my O'Shaughnessy-based value strategy. When looking for value stocks, O'Shaughnessy targets large companies because they have solid and stable earnings, so the strategy I base on his writings requires stocks to have a market cap of at least US$1 billion. With that giant US$340 billion cap, Petrochina is one of the biggest companies in the world, easily meeting this criterion.

O'Shaughnessy also compares stocks to the market average in a number of ways when looking for value buys, including cash flow per share. My O'Shaughnessy-based model requires companies to have a cash flow per share greater than the market mean, and Petrochina's cash flow, at US$15.77 per share, dwarfs the market mean of US$1.53.

Another way O'Shaughnessy looks for large, stable companies: by requiring a firm's trailing 12-month sales to be 1.5 times the market average. Petrochina, with sales of more than $100 billion, easily exceeds 1.5 times the market mean ($18 billion), passing this test.

Aluminum Corp. of China Limited (Chalco): This large-cap (US$34 billion market cap) is the only producer of alumina and the largest producer of primary aluminum in China. The public company was formed six years ago when--as was the case with Petrochina--its formerly state-owned industry was restructured. Last year, it raked in more than US$8.2 billion in sales.

CHALCO, as it is called, is another fast-grower that gets approval from my Lynch-based model. Its P/E ratio of 21.57 and growth rate of 46.4% (based on the average of the three-, four-, and five-year EPS figures) make for an impressive 0.46 P/E/G ratio, which falls into this model's best-case category. You shouldn't expect such high growth to continue over the long term, but the firm should be in good shape if it grows earnings at even half that rate.

CHALCO's debt/equity ratio, 42.01 also appears to be manageable, another reason it gets high marks from my Lynch-based model.

Shanda Interactive Entertainment Ltd.: This Shanghai-based firm offers an array of online entertainment content, ranging from multi-player role playing games to online chess and board games to cartoons, movies and online shopping. It has a market cap of $2.68 billion, and its sales have increased in each of the past five quarters.

With a P/E ratio of 16.40 and a growth rate of 23.5% (based on the average of the three- and four-year EPS figures), Shanda is a fast-grower that sports a favorable 0.70 P/E/G ratio. While the company has been growing quickly, its stock appears to still be selling at a good price.

Shanda's debt/equity ratio--68.37%--isn't great. But it's good enough to come in under my Lynch-based model's 80% upper limit, another reason it passes this strategy.

A testament to Shanda's excellent recent performance is that, in addition to appealing to my Lynch model, it also passes the momentum strategy I base on the writings of William O'Neil. O'Neil says cheap stocks are cheap for good reason: They don't perform well. He believes that--while you'll likely pay top dollar for them-- the most likely candidates for future growth are companies that have had strong past growth. Buy low, and you won't get the chance to sell high, according to his approach; buy high, however, and you'll likely get the chance to sell even higher.

One way O'Neil targets momentum stocks is by looking at recent EPS growth. He likes EPS for the current quarter to be at least 18% greater than it was in the same quarter a year ago. Shanda's EPS this quarter is 217% greater than the year-ago quarter, easily passing this test.

O'Neil doesn't just like earnings to be increasing; he likes the rate of that increase to be accelerating. The model I base on his writings likes it when a company's growth rates for the last two quarters (compared to the same respective quarters a year earlier) are at least 25 percentage points more than the firm's historical growth rate. Shanda's 23.5% historical growth rate is good, but it was dwarfed by the 4,000 percent growth rate it experienced between last quarter and the year-ago quarter, and by the 216.7% jump between this quarter and the year-ago quarter, passing this test.

As I said, O'Neil is a believer in "buy high, sell higher," so he also looks at relative strength, which compares a stock's price performance to the overall market over the past year. My O'Neil-based model looks for relative strength ratings of no less than 80 (meaning that the stock has outperformed at least 80% of all other stocks during the past year). Shanda's relative strength is 95, which this model considers exceptional.

China Medical Technologies: Based in Beijing, this medical device maker manufactures and sells diagnostic products that are used to detect and monitor various diseases and disorders. The firm also makes "High Intensity Focused Ultrasound" products, which treat solid cancers and benign tumors non-invasively. It has a market cap of $1.18 billion.

China Medical gets approval from the strategy I base on the writings of Martin Zweig, in large part because of its strong growth. The company's historical growth rate, 49.09% (based on the average of the three- and four-year EPS figures), more than triples my Zweig-based model's 15% minimum. (Just as was the case with CHALCO, you shouldn't expect the company to keep growing at such a high rate over the long haul. But even if it continues to grow at half its historic pace it would still easily meet this criterion.)

Zweig also wants to know that a company hasn't already reached the peak of its earnings growth. The model I base on his writings calls for a firm's EPS growth in the current quarter to be greater than its historical growth rate. China Medical's growth rate for the current quarter is 50%, which tops that 49.09% historic growth rate, passing this test.

Zweig also believed that, to be sustainable in the long-term, earnings increases should be fueled by increases in sales. China Medical's revenues have been growing at a 70.27% clip, surpassing its earnings increases and passing this test.

China Medical also gets approval from my O'Neil-based strategy. A few reasons why: Its relative strength of 90, its 49.09 historical growth rate, and its 50% growth rate for the current quarter.

Another plus for China Medical: its industry. O'Neil liked firms that were in strong industries, so this model makes sure that at least one other company in a firm's industry has a relative strength score of at least 80. The booming medical equipment and supplies industry has 59 companies meeting or exceeding that threshold.

Baidu.com: This Internet search engine is something like China's answer to the Western world's Google. Its offerings include Internet, image and news searches; a message board user communication program called "Post Bar"; a movie download program; and a system that allows users to ask questions that are answered by other users. The search engine even allows users to enter Chinese words phonetically using the English alphabet.

Baidu, which has a market cap of $10.9 billion, is another momentum pick that my O'Neil-based model likes. Its EPS growth for the current quarter is 150% (compared to the same quarter a year ago), and its annual earnings growth is 160.8% (based on the average of the two- and five-year EPS figures). That shows the kind of impressive recent growth that this strategy looks for.

In addition, Baidu has outperformed the vast majority of other stocks over the past year, as its relative strength rating of 97 demonstrates.

As the success of companies like Baidu shows, emerging markets--particularly one as large as China--can offer incredible growth opportunities. In recent years, we've seen stock prices skyrocket not only for U.S.-listed Chinese companies, but also for their Indian and Latin American counterparts. Sometimes, however, such tremendous potential can be dangerous, luring investors into thinking that any stock in a hot, emerging market is a sure thing. Momentum is great, but in the long run there has to be something concrete behind that momentum for a stock to keep growing.

Sure, some of the stocks that I've mentioned may have trouble continuing their staggering recent growth rates, and a developing market like China could indeed experience some growing pains and setbacks for investors. But each of these companies has fundamentals--be they high earnings, strong sales or manageable debt--that indicate they're more than flashes in the pan. Stick to stocks with that kind of fundamental strength, and your portfolio should benefit--no matter what country you're looking at.

John P. Reese is founder and CEO of Validea.com and Validea Capital Management. He is also co-author of "The Market Gurus: Stock Investing Strategies You Can Use From Wall Street's Best."