Tuesday, January 8, 2013

The Changing Face of Investing in China

Investors looking for a read on the global economy usually take an interest in mining equipment company Joy Global’s (NYSE: JOY) results and in previous years they have had good reason. The two key drivers of its prospects in recent years have been Chinese demand for coal (more or less a proxy for steel demand) and US coal demand. In this article I want to highlight a few economic indicators with which investors can monitor prospects for Joy Global. In addition I’m going to warn that JOY is possibly not going to be as useful an indicator in the future.

US Coal Demand

Starting with the US, the world knows that the shale gas revolution in the US has seen gas marginally replacing coal as an energy source for electricity generation. Indeed JOY pointed out that the share of power generation coming from coal fell to 33% from 43% by April but has risen to 38% as natural gas prices rose in the summer.

In addition in the earnings release it pointed out that coal from the Powder River Basin was competitive at $2.50, then Illinois Basin at $3.00 and then Central Appalachia at $4.00. So if you want to know about JOY’s US coal prospects then I would suggest keeping an eye out for natural gas prices.

Here are spot prices courtesy of the US Energy Information Association (EIA).

The trend has been looking better in recent months but is nowhere near pre-recession levels. Nor is it anywhere near the 2008 boost where a lot of hedge funds purchased natural gas in order to use as energy to produce hot air.

Another great indicator for JOY investors is the US rail carloads of coal from the American Association or Railroads (AAR) which can be accessed here. The coal charts are on page 10 and they indicate a tick up in November but they are still tracking way below the previous years’ numbers. In addition there doesn’t seem to be any slowdown in the US to try and expand gas production. I wouldn’t get too excited by coal just yet.

China’s Fixed Asset Investment

The Chinese economy has been categorized by huge increases in the amounts of investment in housing and construction over the last decade. The question isn’t whether that was where its economy came from, but rather where it is going?

For the current picture, investors can look at the official statistics from the National Bureau of Statistics of China website which is linked here. The latest numbers show a slowing in the rate of growth and particularly from private investment.

It is not hard to see that private sector investment growth has been slowing this year amidst a slowdown in China’s rate of economic expansion.

Now I am going to confess something here. I listen to a lot of earnings conference calls and read a lot of reports and one familiar refrain this year has been the idea that China’s stimulus spending was going to kick in and drive growth in the second half of 2012. Many companies are holding out for hope in this regard and the latest catalyst is seen as coming from the regime change in China.

There are two questions here. The first is whether the stimulus will kick in and the second is which companies will benefit?

Frankly I think that anyone thinking that any upcoming stimulus will change previous plans will be proved wrong. On the contrary the signs are that China prefers to focus on stimulating domestic demand via private investment, consumption and domestically orientated industries rather than in the housing sector or major public infrastructural investments. Unfortunately there is no certainty with these plans but it doesn’t look like the kinds of plans undertaken in 2009 to keep the economy growing.

If Not Construction?

If the thesis that China’s increase in spending won’t necessarily benefit construction and mining then who might benefit? My hunch is that sectors like technology could be set to benefit. The Chinese may be reluctant to undergo another construction boom but they don’t show any signs of wanting to slowdown technological development.

For example, Intel (NASDAQ: INTC) is hoping that China’s stimulus spending is going to kick in and stimulate electronics demand which had been getting progressively weaker as 2012 went on. I discussed the stock in more length here and I like the long term prognosis and the evaluation but would caution against buying it until gross margins are forecast to trough.

Another two stocks that I think should be considered are Cognex Corporation (NASDAQ: CGNX) and Cree (NASDAQ: CREE). Cognex is a play on the increased automation of manufacturing and its potential to grow long term revenue in China is significant. The near term problem is that when companies cut back on investment it will affect all programs and Cognex would be inevitably disappointed with certain programs. As for LED and lighting company Cree I think that it is starting to look very interesting. The LED industry looks set for another upswing in growth from lighting and I think any expectations from significant upside from China street lighting investment should be sedated by now. In other words, any increase in China’s street lighting plans that significantly involve Cree could create a lot of upside surprise.

Any Joy Out There?

Turning back to Joy Global and putting the outlook for US/China coal markets together leads to the conclusion that end markets might not get noticeably better for JOY or other mining and construction focused companies like Caterpillar (NYSE: CAT). Indeed CAT has actually increased its exposure to mining related expenditures with its purchase of Bucyrus. The result of this exposure can be seen in the gradually lowering of estimates for CAT throughout this year.

In conclusion, if you think that China will stimulate its economy with fixed asset investment than go ahead and pick up some JOY or CAT. A second option would be to look at companies more focused on where China might spend or a third is simply to wait and see. I confess I’m in the third camp but watching closely in order to move into the second.

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