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Brace for a Beijing Bust?

Wednesday - 7/3/2013, 2:47pm  ET

The Chinese stock market recently suffered its biggest daily loss in nearly four years after overnight-lending rates soared. Some banks were thought to be paying more than a 20% annual rate in a mad scramble for funds. The stock market recovered after the People's Bank of China (“PBOC”), their equivalent of our Federal Reserve, stepped in to ease the crisis and rates dropped to a still lofty 6%.

Most analysts were relieved that a liquidity crisis seemed to be averted. They felt that PBOC support eliminated most of the danger. But is that the case? Though this emergency has been avoided, a deeper and more prolonged crash could be coming as significant excesses in the Chinese financial system start to unwind.

Identifying the disease, not the symptom

Huge spikes in overnight-lending rates are not isolated events. Such occurrences are usually a symptom of more severe problems within the economy. Interest rates rise violently because a large number of financial institutions, usually overextended into losing investments, have to scramble for money just to stay solvent. Their desperate need for funds puts those with available cash in a position of getting whatever price they want from frantic buyers. This scenario is often described in an excellent book about speculative excess called "Devil Take the Hindmost: A History of Financial Speculation."

The news coming out of China seems to suggest that some sort of speculative bubble has popped. Given the limited amount and dubious nature of the country’s financial information, it’s hard to identify exactly where the problem lies but two likely candidates are the real estate sector and general manufacturing.

Chinese real estate excess has been well documented. Jim Chanos, the noted investor, has laid out a persuasive case many times. A properties crash might be expected after years of overbuilding and profuse investment. Since land development and infrastructure construction has been a key driver of China’s recent growth, such a bust would take a severe toll on the economy. But as bad as that might be, if the bubble bust is related to the manufacturing sector, a collapse there could be catastrophic.

China's rise to being the world’s second-largest economy has been achieved through low-cost production and exports. During a decades long economic boom, it wouldn’t be surprising to find that they have constructed way too much manufacturing capacity. Today, cost competitive regions like South East Asia at the low-end and the U.S. at the high-end have stolen a lot of China’s business just as demand seems to be weakening worldwide. If that means China has significant excess capacity that needs to be disposed, the ramifications could be incredibly turbulent and the recent liquidity crisis might just be the beginning of a torturous decline.

What to do in a bust? Buy low!

Luckily, for the astute investor, a bust in China might be a longer-term opportunity. A cleansing of excess could pave the way for growth at very attractive share prices.

One way to get into the market is the iShares FTSE China 25 Index Fund . This is an ETF that mimics the FTSE China 25 Index, which tracks the share performance of the 25 largest companies in the Chinese equity market that are available to international investors. Because the fund is non-diversified and currently has about 30% of assets in banking and land development companies, its share price will probably be hit hard in any bust. Priced around $32 a share, off from a high of $45 in 2011, it may drop another 20% to 30% during a grave crisis. I'd consider it more appealing in this $22 to $27 range.

China Mobile could be another "buy low" candidate. It is the leading provider of mobile phone services in China with about 726 million customers or about 65% of the mobile market. China Mobile has been testing an exclusive 4G network called TD-LTE in 15 cities. The company hopes to expand this advanced service nationwide after obtaining a government license, probably by the end of the year. China Mobile is the nation’s major TD-LTE provider and appears to have a big advantage over its competition as the authorities wish to license TD-LTE before any other 4G system.

Even with the country in financial turmoil, growth in advanced mobile services would probably not be contained for long. China Mobile's valuation, especially after a large dip, would be attractive. Using a cash earnings times a capitalization multiplier valuation, its fair business value seems to be around $60 per share at a slightly higher than industry average multiple of 10, with anticipated revenues around $90.0 billion and average cash earnings of $24.4 billion,

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