A Cheap Way to Profit from China’s ‘New Normal’

James DiGeorgia

Many in the media are decrying the China slowdown. But that’s because they fail to see the opportunity within it.

Last week Bloomberg wrote about China’s “new normal.” That is, its shift to a slower, consumer-driven economy that relies less on exports for its growth.

The Bloomberg article suggested this will be a boon for the U.S. and particularly U.S. workers.

That’s because increased demand for U.S. goods could mean a shift toward higher prices and potentially higher wages.

On top of that, companies that find themselves at the forefront of this massive shift could benefit in a big way.

As many of you know, I have a favorite stock in the Chinese commerce and Internet space.

Many Wall Street analysts call it a budding “Chinese Amazon.” That’s because if you look at where Amazon was trading 10 years ago, you’ll see this company trading in much the same way.

Granted, Amazon already has a China presence. But the company I’m following could give it some healthy competition.

China Slowdown? Not Here!

Thirty days ago, give or take a few hours, I shared with you my bullish outlook for Vipshop Holdings Ltd. (VIPS), the Chinese Internet discount commerce giant.

(Disclosure: I own VIPS and have held this particular position for just about 60 days.)

Critics of this stock argue that China is slowing down. So, all Chinese companies must be in peril.

Not true!

The fact is, Chinese government-sector spending has been slowing for the past few years.

That’s government spending on roads, highways and infrastructure.

Meanwhile Chinese consumer spending has not fallen and, in fact, continues to grow.

Step by step, China has been building a stronger and stronger domestic consumer economy.

For an online discount consumer products seller, the Chinese economy is doing just fine. In fact, it’s allowing VIPS to grow at a 100% year-over-year rate.

Click the image for a larger view.

One of the big reasons for this growth is that the Chinese culture is becoming well-acquainted with the concept of “discount online marketer.”

Judging by the growth to date, the concept of buying for less than retail is really catching on in China.

I entered my VIPS position at about $22 a share. My target price for VIPS was $29 a share. (It’s now short term $31 a share.)

But right after I entered my position, six critical indicators I watch quickly moved to neutral and then to a clear sell signal.

At that point, VIPS had pulled back to $21 and change.

What Short-Term Bears Can Do

When They Aren’t Ready to Sell

Last we talked on Feb. 16, earnings were due that day. While I was still bullish on VIPS, I was a bit worried about how that report would play out.

In the past, VIPS had pulled back just before earnings.

Many times, VIPS has even flashed a sell signal just before earnings … only to beat estimates and rally!

With my indicators saying “sell” going into the Feb. 16 report, I expected a pop … but wanted to protect myself in case it didn’t come.

Also in the past, VIPS has gotten a great tailwind from the success and growth of other Chinese Internet plays.

Unfortunately, Chinese Internet companies have been struggling. This is thanks to the false “slowing Chinese economy” narrative.

For example, last month Baidu Inc. (BIDU) plunged 10% after missing Q4 earnings expectations. It continued to sink through last Thursday’s trading session before regaining some ground Friday.

Many other Chinese Internet, communications and technology stocks were also high-fliers in 2013 and 2014.

Consider names like Sohu.com (SOHU), SINA Corp. (SINA), Youku Tudou (YOKU) and even the hot IPO Alibaba (BABA) that launched near the end of last year.

Now consider that these same names are STILL down 30% to 60% from their highs — even a month later after I pointed this out!

VIPS, however, stood out from this crowd. And I felt that could be reflected in its Q4 earnings report.

•  In Q3, many more Chinese consumers switched from computers to mobile devices to shop online. During that time, VIPS began upgrading its mobile applications to be more customer-friendly.

•  Q4 also included the China’s “Singles Day” holiday on Nov 11, 2014. The holiday proved once again to be big for Chinese e-commerce players. This year saw stronger online sales thanks to deeply discounted offers and one-time promotions.

Yet, VIPS shares were sagging going into earnings.

Most investors would have cut their position loose after the terrible Baidu report and the level of fear surrounding Chinese stock plays.

However, I too stubborn about VIPS’ ultimate-long term potential to just cash out and sit on the sidelines.

But that didn’t mean I had to risk a ton of money if they reported a lousy fourth quarter.

So instead of closing my positions, I decided to buy “put insurance” as we approached VIPS earnings report. That is, I bought put options to hedge my long shares against a pullback.

An Update on My Put Insurance Trade

Because I owned 1,500 shares of VIPS, I bought enough short-term protection to cover the entire position.

I did this by buying 15 of the VIPS February $20.50 Puts at an average of $60 per contract to hedge my long shares in a 1-to-1 ratio. (Each VIPS options contract represented 100 shares of the underlying stock.)

Here’s how that worked:

•  I bought 1,500 VIPS shares at $22 ($33,000)

•  I then bought 15 VIPS February $20.50 Put contracts at $60 ($900)

•  15 contracts x 100 shares in a contract = 1,500 shares hedged

You can see that I spent roughly $900 on the puts to protect a $33,000 stock investment. That’s an inexpensive insurance policy, when you think about it.

By buying these puts, I essentially added 60 cents to the cost of my position. My cost investment in the 1,500 shares now averaged about $22.60.

I reasoned if VIPS disappointed when it reported last month, it could very easily fall to $12.25 a share — as indicated by the price target generated by the Alpha Scorecard back in February, which always evaluates trading ideas on a free cash flow basis.

If VIPS slid that far, that could have translated into a $10 loss on my position … that is, if I didn’t own put options to protect against a slide!

This insurance policy had two key benefits:

•  It was designed to help me hold on to my shares, and

•  It also allowed me to sleep well while I waited for the earnings report.

How My VIPS Insurance Trade Turned Out

My bullishness in VIP paid off!

I was 100% right that there was more upside to capture. By staying in the shares, I benefited from capital appreciation … even with a higher cost basis per share of $22.60 from buying the puts.

Although the cost of the shares remained well above the $20.50 strike (and they expired without value), I don’t consider the cost of buying the puts to be a waste.

After all, we protect our valuables, our vehicles, our homes and our health with insurance. We still win when we don’t have to use those policies.

The same is true when it comes to our portfolios.

So, not only did VIPS not fall, but the shares have since risen by more than the 60 cents I paid for the insurance.

In fact, VIPS rallied alongside the broader markets last Thursday, trading as high as $27 a share.

And though it pulled back along with the rest of the market on Friday, all six triggers that I’m watching on its chart are now positive.

In fact, they are suggesting VIPS could shoot up to $45 sometime this year …

Bottom line: Owning puts alongside my long shares allowed me to stay positioned in a stock I believe in.

Even if shares don’t hit $45, I expect VIPS can still hit the Alpha Scorecard lower limit price target of $32.32 — which is now 43% higher than the cost of my position ($22.60) in VIPS.

So, I’m up on my 1,500 shares of VIPS I am up approximately 28% from my cost basis.

I may decide to use this earnings-hedge strategy again when the company reports Q2 results on May 14. I’ll be sure to let you know if I do … and how it turns out.

Always Watching Your Chickens,

James DiGeorgia

With contributions from Geoff Garbacz, Dan Hassey, Mathew Schilling, Phil Erlanger and Dawn Pennington

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