Examining Growth and Valuation

Robert Hsu, December 01, 2007

My trips to China are more than just checking out new companies and seeing the growth happening there. For me, it's about connecting with subscribers and finding out exactly what interests readers like you. The most common question I received from members of our Investment Tour this time around was about the high P/E ratio (or price-to-earnings ratio) of some of our stocks.

Most individual investors use a simple valuation method based on a trailing 12-month price-to-earnings ratio in order to determine whether a stock is cheap or expensive. This is actually an oversimplified way to evaluate stock valuation. Just because a stock has a high P/E ratio doesn't mean it's overvalued, and conversely, stocks with low P/Es are not necessarily undervalued.

Let's look at Mindray Medical as an example. Mindray trades at a current trailing 12-month P/E ratio of 55. The company's earnings grew by 70% during the past year. If the stock price stays the same and the company's growth rate continues at the same pace, in two years, the company's P/E ratio drops down to a much more modest 19. The reality is that most great growth companies that have created life-changing wealth for their shareholders -- such as IBM during the '60s and '70s, and Microsoft during the '80s and '90s -- have always traded at a significant premium to the rest of the market. These stocks command a premium market valuation as long as they maintain their superior earnings growth. The same concept applies to our China Strategy stocks as well.

Recent news reports compare the current bull market in Chinese stocks to the Internet bubble of the late 1990s. Although we are seeing some signs of speculative mania beginning to develop in China, the underlying fundamentals in our Chinese stocks are far superior to Internet stocks in the '90s. First of all, all of our companies are profitable and growing their earnings rapidly, while most Internet companies back in the '90s lost money. Secondly, our Chinese stocks have assets and earnings denominated in Chinese yuan, a rapidly appreciating currency. Internet stocks didn't have the currency tailwind behind them. Third, our stocks operate in an economy that's growing at 11% a year, whereas Internet companies were operating in a slower-growth economy.

The fact of the matter is that if a company can deliver superior growth, its stock price will go up over time. The few Internet companies that made money and delivered superior earnings growth managed to go up even after technology stocks topped out in 2000. Online auction giant eBay, for instance, tripled in value between 2000 and 2005.

I don't want you to confuse my defense of high P/Es for market exuberance. After the big run-up we've had over the past two months and the slowdown in U.S. corporate earnings, I think it's time to be more cautious towards stocks -- even Chinese stocks. Just a few weeks ago, I issued a special Flash Alert to sell two of our stocks and take some chips off the table. In the short run, volatility is high and we need to protect some of our profits. Over the long run, as long as earnings continue to grow, our companies will continue to beat the market and reward us generously.

Sincerely,

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