Are these two stocks good value or value traps?

There are two stocks that have caught my eye over the last two days. Both of them have seen their share price decline substantially, both of them mostly for geopolitical reasons and in both cases, China is involved. Thus, your assessment of how China will act in the next few months will play an important role in your assessment where the share price will go.

Let’s start with Cathay Pacific:

The flagship carrier of Hong Kong had to cancel several hundred flights as the protests in Hong Kong led to a shutdown of the airport for two days now. Apparently, more than 14,000 employees of Cathay Pacific participated in the Hong Kong protests and went on strike. On 8 August, Chinese state media warned that workers who participated in the strikes could be arrested in China. In reaction to that, the airline banned workers who were involved in the strikes from flights to and from mainland China.

But wait, it gets better. On Friday, China ordered the airline to fire any worker who participated in the strikes. Note that while Cathay Pacific is controlled by the Swire Group who owns 45% of the shares, the Chinese government-owned airline Air China also holds 30% of the shares. The combined economic power of China as a destination for Cathay and its power as a shareholder was irresistible to the company management and on Monday it announced that any employee who participates in the strikes could be fired.

In reaction to this Chinese blackmail, the share price of Cathay dropped to a ten-year low in the last two days. Today, the shares trade at a P/E-ratio of 9.5 and a price/book-ratio of 0.66. Is this cheap enough for an investment?

In my view, it is cheap and though I am not an equity analyst, my guess is that the fear about a Chinese intervention in the business of Cathay are overblown. What is clear is that with the blackmail of Cathay Pacific the Chinese government has crossed a line and for the first time (at least to my knowledge) actively intervened in the business of a Hong Kong company for political reasons. This is stuff we normally only see in countries like Russia. And from this perspective, the shares of Cathay warrant a valuation discount, just like the shares of many Russian companies do.

But is China really going to crack down hard on the protests in Hong Kong? In my view, no. China is well aware that it needs to keep the investment and trade flows in and out of China alive. It already is under pressure from the trade war with the US. If the Chinese government would intervene militarily or economically in Hong Kong it would spook pretty much every Western business in Hong Kong. The result would be a massive crash in the economy of Hong Kong (the local economy is already heading for recession due to the protests) and an immense loss of trust that would spill over to businesses on the mainland.

To put it bluntly: if China wanted to pull off another Tiananmen Square style crackdown, it had done it already. There are Chinese tanks and soldiers stationed in Hong Kong anyway. But it didn’t and for good reasons.

I think that China is trying to let these protests fizzle out and seems surprised how ferocious and enduring they are. In the end, I think China will have to make some political concessions to the protesters that are so minimal that nothing much changes. For example, the Chinese government could drop the current Chief Executive and grant the population some more rights in electing the Chief Executive in the future. After all, the example of Russia shows that you can let the people vote and don’t have to manipulate the election as long as you control who is able to run for office in the first place. It’s called “managed democracy” in Russia and China could implement a similar system in Hong Kong. Given this outlook, I would expect that nothing much will happen to the workers of Cathay and that once the airport opens again, the share price of Cathay should start to recover. This doesn’t make Cathay a value stock, but it doesn’t look like a value trap either to me. I think, Cathay provides a short-term opportunity to benefit from excessive pessimism of Mr. Market.

The risk, of course, is that my assessment of the protests is wrong and the situation gets worse and eventually out of control. But in that case, it is not only Cathay Pacific that will suffer. In that case we should expect a massive shock to the Chinese economy overall and with it a global market correction or even a bear market.

Share price of Cathay Pacific year-to-date

Source: Investing.com

The second stock that caught my eye is US agribusiness company Deere & Co:

On Monday, the US Department of Agriculture crop report showed that farmers in the US planted more corn than analysts expected. In reaction to this news, corn prices dropped 6% before the market was stopped automatically and Deere shares dropped 5% as well. The shares of Deere are well on their way to their May lows.

Of course, the trouble for Deere didn’t start with corn planting statistics. The sharp drop in share price in May hints at the real reason. As the trade war between China and the US heats up, US farmers have nowhere to sell their crops to and as a result, US grain prices have declined precipitously. Thus, an investment in Deere is directly linked to the ups and downs of the trade war.

And this is where my skepticism starts. At the beginning of the year, I was optimistic that the trade war between the US and China could be resolved by the summer. But when Donald Trump stepped away from the talks and China retaliated by stopping its purchases of agricultural produce and other US goods, the window of opportunity closed. Now the US Presidential election is on the horizon and Donald Trump has very little incentive to find a solution in the trade war with China. Instead, a continued escalation of the trade war could help Trump rally his supporters as long as the damage to the US economy is limited.

In this regard it is notable that the latest round of tariffs have been postponed to 15 December in order to reduce growth risks. The question for Trump is if the Fed will do his bidding and cut interest rates aggressively for the rest of the year. In this case, the stimulus of the Fed could give him enough leeway to escalate the trade war. But if the Fed shows restraint, then we should expect additional attacks on the Fed by the President and potentially further delays in the additional tariffs. Nevertheless, a resolution of the trade war seems a long way off at this point in time.

Thus, even though the P/E-ratio of Deere is reasonable at 14.9 and the share price could rally if the company posts good third quarter results on Friday, it seems unlikely at the moment that the shares are cheap enough and the risks small enough to warrant an investment. To me, Deere is simply a play on the whims of Donald Trump and indirectly a bet on steep rate cuts by the Fed. Both are not good reasons to buy the stock because both seem impossible to predict to me. 

Share price of Deere & Co year-to-date

Source: Investing.com