The New Breed of Top China Stocks -- Barron's Asia

By Jack Hough

To find winning stocks and avoid losers in China, pay attention to the priorities of the ruling Communist Party.

A new report by Nomura argues that a long-term overhaul of the Chinese legal system bodes well for two sets of domestic companies: information technology specialists and manufacturers whose investment in product development gives them an edge over rivals.

Top picks include Baidu (ticker: BIDU), CSR (1766.HK), and SAIC Motor (600104.CN).

Every new Chinese leader promises to fight corruption -- no easy task in a country where the ruling party oversees itself. Xi Jinping, who took over as party chief in November 2012, has indeed taken on big, sweeping official corruption cases.

Investors who took Xi's early anticorruption talk seriously would have known to avoid shares of luxury-goods sellers, whose wares have long been used as bribes in China, as well as casino operators in Macau, an hour's ferry ride from Hong Kong where jewelry and pawn shops have been favorite destinations of wealthy Chinese looking to move money out of China. This year, luxury-goods sales in China are expected to slow for the first time in more than a decade, according to Bain & Co., a consultancy.

Hong Kong-based Michael Kors Holdings (KORS) stock is down 15% this year; Prada (1913.HK) has fallen 31%; and Compagnie Financiere Richemont (CFR.Switzerland), whose brands include Cartier, is off 7%.

Meanwhile, Macau table gaming revenue is on pace to decline 17% to 21% this month versus last year, according to a Tuesday morning note from investment bank Sterne Agee. Sands China's (1928.HK) and MGM China Holdings' (2282.HK) shares are down 27% this year and Wynn Macau (1128.HK) has lost 23%.

The next theme for investors to watch is rule of law, according to Wendy Liu, head of China equity research at Nomura, a Tokyo investment bank. "We have found it more useful to listen to Beijing on what it plans to do vs. debating what it should do, as equity prices ultimately follow real actions," wrote Liu in a Monday note to investors.

Liu writes that China's focus on economic growth above all else has brought ill side effects including corruption, pollution and inequality. The Communist Party now aims to use judicial reform as a foundation to address problems and create balanced growth. It may have little choice, considering rising public demands for reforms and lessons learned from the collapse of the Soviet Union. Among many goals the Party has published are to write better laws, establish checks on administrative power, and promote a more empowered and independent judiciary.

Reforms will take many years to carry out. The job of governing a population of nearly 1.4 billion using a political party with more than 86 million members will be affordable only with significant use of network technology, according to Liu. Her top picks in the space include search specialist Baidu, electronics maker Lenovo, Semiconductor Manufacturing International (0981.HK) and ZTE (0763.HK), which makes network equipment.

At the same time, protection on intellectual property will be expanded and more business will be awarded on the basis of competency rather than relationships. Liu sees that benefitting BYD (1211.HK), which makes components for cellphones and cars; CSR, a maker of railcars; Great Wall Motor (2333.HK), which specializes in sport utility vehicles; SAIC Motor; and Sunny Optical Technology (2382.HK), which sells lenses for cellphone cameras and looks likely to benefit from a push toward camera-based safety systems for cars.

Nomura's company analysts, in separately published research, rate Lenovo (0922.HK) a Hold and the rest of these names Buys.

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