If you’ve been laser-focused on inflation and Federal Reserve policy, you may have missed a major breakthrough in US-China relations that will boost US-listed Chinese stocks over the next six months.
But first, here’s the background on this important geopolitical development for context, courtesy of China expert Brad Loncar. He is the creator of the Loncar China BioPharma CHNA exchange,
which offers a way of broad exposure to Chinese biopharmaceutical companies. (You can read more about the ETF here.)
The Ghost of Enron
Years ago, after the tech bubble burst in 2000, US auditing firms came under fire for not reporting publicly on accounting shenanigans that cost investors tons of money – including the poster child of the era, Enron. In response, Congress created a watchdog of auditors known as the Public Company Accounting Oversight Board (PCAOB).
China’s government has never given U.S. inspectors a look at the books of Chinese companies, for fear of revealing state secrets at its big state-owned companies. A few years ago, Congress said enough is enough and passed a law that says Chinese companies will be pulled from US stock markets if they don’t play along soon.
A standoff ensued, which only ended on August 26 when the China Securities Regulatory Commission and the US Securities and Exchange Commission (SEC) agreed on inspection protocols.
“I always thought they would come to an agreement because it is not in China’s interest to lose access to the world’s largest financial market,” says Loncar.
But the devil is in the details. So it remains to be seen how much cooperation US regulators get later this year when they try to carry out inspections.
“There’s still a question of whether these audits will go smoothly,” Loncar says, echoing cautionary comments from the SEC.
The deal will make sense “only if the PCAOB can actually fully inspect and investigate audit firms in China,” warns SEC Chairman Gary Gensler.
This is still a plus for US-listed Chinese stocks, as no one knows the outcome for sure. But, like Loncar, I believe he will succeed.
“As controversial as China is,” Loncar says, the breakthrough this week “is a sign that China still wants to be part of the global financial community.”
It seems unlikely that China will signal cooperation, only to reverse course. As this becomes clear later this year, when US inspectors attempt audits, it should strengthen US-listed Chinese companies.
Here are three of my favorites.
If the US ever needed a brand ambassador to curry favor with everyday Chinese citizens, it could do worse than appointing Yum. KFC and Pizza Hut outlets are incredibly popular there. Now Yum is in the process of launching Taco Bells. Yum is also developing several emerging brands that it wholly owns.
All this makes Yum China the largest restaurant company in China. It operates over 12,000 outlets in 1,700 cities, including 8,400 KFCs and 2,600 Pizza Huts.
Owning Yum is more than a gamble to solve a thorny international accounting issue. It’s also a bet that Covid eventually recedes into the background – to circulate in various, less pathogenic forms, as the Spanish flu did. This still comes out every year, but hardly anyone notices it, because it has become much tamer. That’s how flu viruses evolve, and if Covid continues to follow the same path, it will boost Yum China’s sales.
Earlier this year, Yum had to close more than half of its restaurants due to the lockdown in China. In the first quarter, same-store sales fell 8% and margins slipped.
Yum is also benefiting from rising disposable income in China. People eat out when they make more money.
Like Yum, China’s retail, cloud computing and media giant Alibaba is suffering from the country’s lockdown-related economic malaise.
“Everyone understands that China is at a different point in the economic cycle than the rest of the world,” says Justin White, manager of T. Rowe Price All-Cap Opportunities Fund PRWAX.
But as China’s economy recovers because Covid recedes, Alibaba could get a boost, White says. That’s one reason he recently took a position with the Chinese Internet giant.
“Economically, China could improve in 2023 when the rest of the world is not,” says White. “Alibaba’s fundamentals are more likely to improve than slow.”
White is worth listening to because his fund has outperformed its Morningstar Direct category and benchmark by several percentage points over the past three years.
Meanwhile, Alibaba continues to invest in international e-commerce platforms to drive long-term growth, says Morningstar Direct analyst Chelsey Tam, who has a five-star (out of a possible five) rating on the stock.
Larry McDonald, who writes the Bear Traps Report, singles out Alibaba as the favorite, on technical grounds. He notes that the China Golden Dragon Equity Index recently retook the one-year downtrend line from above and rebounded sharply.
“We see a rise in Chinese stocks in the coming weeks,” he says. “Clearly there was a capitulation-selling washout in these names in March. That last leg down is another bite at the apple. We expect a dramatic outperformance relative to US equities in the coming months.”
BeiGene is a giant cancer treatment company with a twist. It has a large presence in China, where it serves as a gateway for other major biopharma companies looking to sell treatments there — such as Amgen AMGN,
and Bristol-Myers Squibb BMY,
In total, BeiGene has the rights to distribute 13 approved drugs in China.
That makes the company’s stock particularly sensitive to the ebb and flow of US-China geopolitical tensions. So when, or if, the accounting issue is decisively resolved, perhaps in December, the stock should take another rally. A large company like BeiGene needs access to US capital markets.
BeiGene is much more than a drug delivery pipeline. Second-quarter revenue rose 120% to $304 million, thanks to rapid growth in sales of the cancer treatments it developed, Brukinsa and Tislelizumab. Behind the scenes, BeiGene has nearly 80 ongoing and planned clinical trials on over 40 drug candidates. More than 30 of these are “pivotal” late-stage trials. This means they could provide the data they need to apply for approvals. Its broad pipeline covers 80% of the world’s cancers.
Accounting firms’ problems aren’t the only problem here, notes Loncar. The company has manufacturing and research facilities in New Jersey, but also has manufacturing plants in China. In July, the Food and Drug Administration (FDA) filed for approval of a biologics license application for the use of Tislelizumab in the US, citing a failure to inspect Chinese plants.
If China continues to lift its lockdowns because Covid subsides, FDA inspectors may be able to come in and give the green light. Of course, with the FDA, you never really know what problems might crop up, so there’s no guarantee that this is the only problem with Tislelizumab being approved in the US
But the tone of the company’s comments on the matter suggests that may be the case. “The FDA only cited the inability to complete inspections due to travel restrictions as the reason for the delay,” says BeiGene, which did not offer a timeline for when that issue might be resolved.
BeiGene is run by founders, often an asset in investments. CEO and President John Oyler is a co-founder. It also has research collaborations with big names in the field such as Amgen and Novartis NVS,
This serves as a stamp of approval on my system for analyzing biotech companies.
Michael Brush is a MarketWatch columnist. At the time of publication, he owned YUMC, BABA and BGNE. Brush has recommended CHNA, YUMC, BABA and BGNE in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.