When the Yuan Strengthens...
posted by The Traveller on Sunday, March 21, 2010

There is widespread talk about an upcoming revaluation of the Chinese currency, the Yuan (Renminbi). While certain circles in the U.S. try to make the case for a currently undervaluation of up to 40% it seems inevitable that China will be forced to let their currency appreciate in the 5-10% range this year. So what would this mean for investing in US-listed Chinese Small Caps?

First of all the obvious: all US-listed companies report in US Dollars, including the China based companies. Any Chinese company that is doing their business in local currency will be able to record a foreign exchange gain equivalent to the valuation gain of the Yuan. And that is unrelated to actual business developments. The whole group of US-listed Chinese companies will benefit from a stronger Yuan.

You want to look for companies that do pretty much their entire business in China. Most of the agricultural and food stocks fit into this category. Let me single out Skystar Bio-Pharmaceutical (SKBI) as a good value play right now. Despite its name SKBI isn't your typical healthcare company as it produces micro-organism products, feed additives and veterinary medicine and vaccines for poultry, livestock and aquacultures. They produce and sell all of their products in China and with a P/E ratio of 6 the stock is currently in the bargain bin. Those with a faint heart might want to wait until the company reports earnings which are due by the end of March.

But it doesn't stop here. There is a whole sector that will enjoy a double benefit from a possible Yuan revaluation: Companies who primarily import their raw materials from international markets like Europe or the U.S. (in US Dollars) and sell their manufactured goods primarily on the domestic market (in Yuan).

Take Orient Paper (ONP), a producer or paper and packaging related products. The company uses recycled waste paper as its primary raw material which it buys from a variety of suppliers. Those suppliers will likely source a good part of their waste paper from the U.S. and Europe as China is just the number one destination for our recyclable materials. Orient Papers sells their finished good entirely on the domestic market so all of their revenues are recorded in Yuan. The stock is currently cheap after a massive sell-off last Friday which was likely triggered by reports the company had dropped out of an investor's conference (a report that has been labeled as a misunderstanding by the company). If you want to reduce risk you might want to wait until the dust settles and ONP reclaims the $9 support level.

But there is one group of companies that will have a disadvantage from a stronger Yuan. All of those that fit into the stereotypical category of Chinese manufacturer with cheap labour and resourced that exports its products to Europe and the North America. Think of all of those neatly cheap products at Wal-Mart, clothes and IKEA furniture, and also all of the contract manufacturers. Their cost of sales will rise with a stronger domestic currency and it is not very likely that Wal-Mart, IKEA and co. will be willing to pay more for the goods. It will depend on the size and scalability of the manufacturer if they can adjust to a stronger Yuan, but overall it should put strong pressure on their margins.

I would strictly avoid investing in any small cap or micro cap company with a business model that entirely relies on exporting cheap products to the international markets. A company that is too small to deal with a possible 10% rise in raw materials and labour cost will struggle to survive, and that is probably the main reason why the Chinese government is trying so hard to defend its undervalued currency as "fairly valued."

One example would be China Linen Textile Industry (CTLXF), a Chinese manufacturer of linen products for the textile industry. As the company stated in their last annual report, "consumers for linen textile products are currently mainly in foreign markets outside of China." CTLXF's customers include well known brands as Boss, Marks & Spencer, H&M and Zara and in its latest presentation the company identified China, Italy, USA, Brazil, Belgium, Spain and Greece as its top customers' markets.

It seems likely that China Linen's competitiveness would be harmed by a stronger Yuan, and while we don't know how well the company might be prepared for such a development it should be noted that they do already have a warning in their annual report: "should the Renminbi appreciate against the U.S. dollar at that time, our financial position, the business of the company, and the price of our common stock may be harmed."

Those three stocks portrayed are just examples from their respective groups, I could have picked several others that fit into the same categories. Bottom line is: it might be wise to be at least partially exposed to the US-listed China Small Caps sector when the actual news of a Yuan revaluation hits the markets.

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