Motley Fool Hidden Gems Investing - The Challenges of the China Market

Starting point is 00:00:00 The challenge of China's market today on Motley Fool Hidden Gems Investing. Welcome to Motley Fool Hidden Gems Investing. I'm your host, Tyler Crowe, and today I'm joined by longtime pool contributors, Matt Frankel and John Kloss. So we're going to really dive into the challenge that a lot of companies have been facing in China recently. we discussed it yesterday on yesterday's podcast related to Nike's earnings. We're going to scratch that a little bit deeper because there's a lot more companies than just Nike that are suffering this problem. But before we do that, it is July 2nd. Well, we're recording on the 1st, but hey, you know what? For you guys, it's the 2nd. That means we're more than halfway through the year.

Starting point is 00:00:46 And so far, the S&P 500 has been a wild, wild place. We've had some incredible performance up and down the spectrum. And I got to say, guys, I think so far this year, I think I've seen the widest spread of outcomes in the S&P 500 in a long time. Well, yeah. I mean, first and foremost, if my math is right here, we had 22 stocks double or more in the first half of 2026. Now, I'm talking about 22 stocks among the constituents of the S&P 500. That doesn't seem normal to me. I haven't checked the historical data, but having that many stocks, double or more, I mean, we look at some of the higher end stocks, the top five, I mean, it's far more than that. So to have the, these are the largest US-based profitable companies, to have this many going up this fast, it just is remarkable. To your point too, John, it's not just like, you know, the smallest companies going from like 20 billion to 40 billion. This is like Micron going from 500 billion to a trillion dollars in six months or so. Not the specific one, but you know, that's an example, like massive companies making massive moves. I feel like there were two tales of the first half, too. Like the first quarter was ruled by by fear. You had the Iran war starting. You had the saspocalypse trade. That was all during the first quarter of the year. And then the second quarter was all optimism. I mean, the Iran war ended and restarted 78 times. And each time the market rerated and had some positive, you know, some optimism there.

Starting point is 00:02:22 You know, we saw the AI trade really start to pick up, especially when it comes to like the picks and shovels plays. For the first time since 2003, small caps outperformed the S&P 500 for the first half of the year by a significant margin. And I mean, we saw a lot of kind of unique aspects of this year. You're right. It was kind of a roller coaster ride. The S&P 500 is up for the year, but it was not a straight line getting there. Yeah. And something you mentioned too while we were pre-taping is, I think this is the first time in a while that the magnificent seven stocks were actually underperformed the S&P 500 on a total basis. So a lot of wacky Wednesday, everything is upside down sort of feeling to what we've seen so far this year. Now, like you said, a lot of the things that we've seen so far have been like solid trends. And I think people who have been listening to the show kind of caught on to like what's done well, what's done great. Stuff that stinks is like SaaS companies and not doing necessarily well because, you know, death of AI and then AI

Starting point is 00:03:21 infrastructure companies are the ones that are, we're actually killing it. You know, we're talking about the chip companies. A lot of the tangential industrial companies are associated, but there's a lot of other like hidden aspects and like maybe unconventional winners so far in the S&P 500. So guys, what did you like when you look down the list and we kind of scoured them a little bit before the show, which one popped out as like, hey, this is doing surprisingly well. It's not correlated with these megatrends that we're talking about here. Yeah. I mean, to your point, it's basically the AI infrastructure buildout that is among the top performance in the S&P 500. But if you go down the list of ways, number 51. So this doesn't even crack the top 10%, but this is

Starting point is 00:04:00 Casey's General Store and that ticker symbol C-A-S-Y. This is a Midwestern convenience store and gas station chain. And it was up 41% in the first half. That's a tremendous six-month performance. It doesn't even crack the top 10% of the S&P 500, which is just remarkably laughable to me. But with gas prices going higher, I wasn't surprised that people were spending on gas necessarily. But I was wondering, is this consumer discretionary spend going to come under pressure? Well, restaurant sales, I mean, they were kind of under pressure here in the first half of the year. But you look at Casey's, where it really makes its money is in the prepared foods part of its business. People go to the gas station. Now you can get kind of

Starting point is 00:04:46 these grocery items as well, but the prepared foods are close to a 60% margin. So this is the real moneymaker for the business. The same store sales for prepared foods up 5% in the first half of its fiscal 2026, which just ended here in April. But that's a very strong showing in more of like the restaurant category here for Casey's, and it is driving a lot of its outperformance right now. Yeah, I think my biggest surprise, and Tyler kind of mentioned this, was that the MAG-7 underperformed the S&P 500 for the first time in a while, and was how well the S&P 493 did, the other, you know, every other company in the index as a whole. I mean, there are some obvious examples of companies that are benefiting from the second wave of AI, and that's really what's

Starting point is 00:05:30 driving it. You know, the big, the hyperscalers already had their benefit in the past few years. Just think companies like Micron, that's Tyler mentioned earlier, and SanDisk, the memory companies are obvious examples. But then if you look at kind of picks and shovels plays that are a little below the radar, like Corning is a big surprise to me as how well it's done. GLW is the ticker symbol. It's a 175-year-old company that's a specialty glass and fiber-optic cable maker. And companies like Corning and others are being revalued as AI infrastructure plays because they're benefiting from that massive wave of data center spending. So companies like that, I think are the biggest positive surprise to me. And there are several

Starting point is 00:06:10 other examples of those. I think we're going to have to talk to the production team. I think we need to do like a field research road trip and we'll do like a Casey's, Bucky's, Wawa, all of the like hyper loyal customer base convenience stores across America. That could be a fun little research topic. Like we said, these are some of like the unconventional winners. And like we said, the losers, you'll find a ton of SaaS companies, things like that. A lot of tech software companies, I guess is the best way to put it. But obviously there's some down in the loser category. Same thing, like unconventional losers. What were some of the things that you guys found that really like popped off the screen there? For me, it was Tractor Supply Company. This is ticker symbol T-S-C-O.

Starting point is 00:06:51 it's down 36 percent in the first half of 2026. That makes it the 17th worst performer in the index. Now, the company is forecasting some kind of tepid top line growth as well as EPS growth for the year. So I'm not necessarily surprised it's underperforming the index, but I am surprised that it is down so sharply because it is still forecasting modest growth. It's not like the business is falling apart. So it's actually down 50% from its all-time high, which is its biggest drawback in more than a decade. So that really surprises me. Personally, this is a dip I took advantage of because I think that Tractor Supply Company is just a rock solid business year in and year out. I think that its customers really do rely on it for a lot of things such as their

Starting point is 00:07:39 animal feed. This is a good dividend growth company as well. 17 consecutive years of raising that dividend. I do have a place in my portfolio for dividend growth companies. And with the yield at close to 3%, that's an all-time high for tractor supply companies. So it's one that I went ahead and added in the first half. Yeah. I mean, there are some of the S&P 500 companies that perform poorly that I really wasn't surprised about. Intuit is at the bottom of the list. They should be worried about AI disruption fears. They make a lot of sense for this business on both the tax prep and the QuickBooks side of the business. One that really wasn't on my bingo card to fall 37% this year was FICO or Fair Isaac Company, the company behind the dominant credit

Starting point is 00:08:21 scoring system. Yes, they're a SaaS company, but just the dominance, the relationships they have, I thought were more of a moat than they turned out to be. For the first time ever, we're really seeing serious competitive threats. Like mortgage lenders can now use the Vantage score, which is the number one competitor for the first time ever. And there are legitimate questions about how big of a moat their proprietary scoring system is, which has been a very well-kept secret over the years, if AI's capability of evaluating consumer credit risk improved to the point where it's not really needed anymore. So that's one that surprised me. Yeah, I feel like a lot of that will also come down to not only can AI do it, but will regulators let AI do it? So fascinating story to see how

Starting point is 00:09:04 willing, we're going to cede all of our underwriting to the AI. Coming up next, we're going to talk about the challenge of selling into the China market recently. So on yesterday's show, we took a look at Nike's earnings. And one thing that stood out to me when I was on the show there is the sales declines in China. And this is like a multi-year trend that's been going on. Nike's China sales are down like 30% than they were like five years ago. And I wanted to pull on this thread some more, and you start to see this recurring theme with a lot of other companies. The top story in the Wall Street Journal this morning, business section, was declining market share for non-Chinese automotive companies in China.

Starting point is 00:09:48 This comes on the heels of Starbucks selling a majority stake in its China operations to a local private equity firm. There's numerous consumer brand companies, especially in the beauty and health, personal care space that we've seen large retrend declines, mostly because of weak China sales. So there are a few of the many stories out there that where China was once a major growth engine for a company, but now it's becoming a headwind. And guys, there's a couple reasons for it. But what to you are some of the things that you're seeing that could help explain this

Starting point is 00:10:22 phenomenon? Well, I think that one thing that stands out to me is that China is capable of making really high quality products now. You think about how it used to be. It used to be, if you wanted to save money, you bought a Chinese product. If you wanted a quality product, you bought American. And that's no longer the case. This is a trend that economists have noted for a while, but I don't think that that has sunk in to the consciousness of the general population. It's just entrenched in our minds that China makes low quality products. But in reality, they've really upped their game. Their manufacturing capabilities are incredibly

Starting point is 00:10:56 modern and incredibly tech heavy. And so it's actually able to compete on both the low quality products for just cheapness, but also your higher end quality. They do have viable alternatives to some of these American brands. And what is interesting is because it has invested so much in the manufacturing infrastructure, it's really hard for American manufacturing to compete on price. And so China does have some advantages when it comes to that. And I think that that does make its products a little bit more of a viable alternative and does put some pressure on American companies. The other side of it is their Chinese consumption has declined significantly. China went from being one of the highest growth economies that our companies can get into.

Starting point is 00:11:41 Vehicle sales in China fell 20% year over year in the first quarter. There's a lot of other cases or other industries where we're seeing declining consumption. And John's right. China's manufacturers are making higher quality products than ever before. They're innovating at a faster pace than we've seen in ever before. And the combination of those two things are making it really hard on American companies to find growth in China. The weak domestic market forcing everyone to find markets elsewhere has been a big thing. I saw an incredible statistic where it was like, I think it was 20 something percent of sales in broader Southeast Asia of like electronics, cars and stuff like that were Chinese in 2014. And now it's like 64% really going to show like

Starting point is 00:12:23 they're starting to dominate some of their regional markets as well. I mentioned some of the companies that have already suffered a little bit, but guys, what are some of the companies on your radar that maybe have not seen the China headwind that we've talked about with like Nike and others, but could be facing it rather sooner rather than later? There's a difference between having seen the Chinese headwinds and having it priced into their stocks. So one I want to call out is Apple. Apple is a company that has been meaningfully losing market share in China for years. I mean, the company has resorted to heavily discounting some of its products in China. And that's a practice, as we know, that Apple doesn't really do in the U.S.

Starting point is 00:13:00 I mean, luxury good makers in general are another example. LVMH is a big one. They specifically cited that China's slowdown as an earning headwind. But I see Apple as the biggest not yet priced in story. Huawei, their quality of their smartphones have just grown exponentially. And this could keep part of Apple's revenue base that's tied to China declining for years to come. For my part, I don't want to sound the alarm yet because I don't think that this is a problem necessarily yet. But AI memory is a huge, huge trend right now. There are companies enjoying just unprecedented profit margins because of how in demand their products are and how little supply that there is, that is a trend that I do foresee continuing for some time. However, we do need to

Starting point is 00:13:48 make note of some advancements, potentially advancements, in the Chinese market, and that's from Chongxin Memory Technologies. It reportedly just reached parity with Samsung and SK Hynix with their memory products. Now, they would still need to level up just a little bit more to really start taking on the top high-bandwidth memory generation 4 products that AI really needs, But it is closing that gap. And if all of a sudden a Chinese technology company could release a memory product that is on par, it might be able to siphon off some of the market share, at least in the international markets, which would disrupt the supply and demand imbalance in the memory market. Guys, I want to test out like a working investment thesis. It's not on a particular company. It's a little bit more of a theme. The companies we've mentioned, Nike, Apple, some of the memory companies, a lot of these companies benefited in the international growth phase immensely. You know, from I would say like starting with like NAFTA in 1990 all the way up until 2016, 2017 was this long tail growth of globalization, entering the Chinese market, entering global markets. And a lot of these companies became dominant players in the international markets like China.

Starting point is 00:15:02 And I'm starting to think that now that these mature companies, the ones that have gotten to the points like we need to win internationally, especially in China and Southeast Asia, to grow our businesses further, I feel like those are weaker ones. and companies that not have yet reached the, we need to start winning internationally to grow. We can, we still have a lot of room domestically. I feel companies in that phase are likely better investments today because the international markets are just far more competitive than what they used to be. So that's my working thesis here. What do you guys agree? Disagree? Where should I tweak this? I think directionally, you're right. Many international markets, especially China, have become far more competitive over the past decade or so. And it's big. I mean, consumption's declined. You're competing for a share of a smaller market

Starting point is 00:15:52 with companies that are doing it better. I mean, companies like Starbucks, like Nike, like the automakers used to use that easy growth from international expansion playbook, and you simply can't do that anymore. And I mean, when you look at the top 10, 20 performers of the S&P 500 so far this year, they're almost all U.S.-driven businesses. They get most of their revenue domestically. But that's not to say that international's never going to be a big growth driver again. So I would refine that thesis to say the best move isn't to avoid companies that are pursuing international exposure. It's to favor companies that have more of a focused international strategy built on, you know, mastering a certain market or a certain

Starting point is 00:16:29 technology in a certain market that have really a focus. Yeah, Tyler, I would disagree with you slightly. It's really hard for me to imagine a company that, especially a technology company that does well over the long term that doesn't compete well internationally. Maybe there's a case for a retail chain in the US or a restaurant chain that it doesn't need international to provide good shareholder returns. But a lot of these companies, if they are going to be some of these life-changing investments, the ones that we want to own, chances are they're going to have to go to the international markets for growth, and they're just going to have to win in spite of the competition. And I halfway wonder, with some of these companies that are doing poorly

Starting point is 00:17:10 in China. It used to be an easier game. I'll concede that point to you. And I wonder if some of these early movers in China just didn't get lazy with how easy it was to just bolt on China operations and then start getting incremental revenue. And now all of a sudden it's harder and they were caught with a sleep at the wheel because some companies are doing well still in China. And one that I'd like to point out is Decker Outdoor. This is ticker symbol D-E-C-K. hey, this is a parent company of shoe brands, Hoka and UGG. You know, it's really still growing sales in China. It's selling them for full price.

Starting point is 00:17:43 So it's maintaining those strong profit margins. And management says there's only 30% brand awareness yet in China. So there's potentially still room for ongoing growth in China. So I think that some companies are competing well. And I think that those deserve some attention. Slight shout out to Hoka because I just got my new Speedgoat 7s. And I gotta say, that is a fantastic product. They're not even paying me to say that.

Starting point is 00:18:05 free advertisement. There you go, Decker's. Coming up after the break, we're going to hit the mailbag. Hey, everyone. Here's a quick reminder. As always, if you want to get your question read on air and for us to answer it, go to podcasts at fool.com. That's podcasts with an S at fool.com. Always remember, keep it foolish, keep it short enough we can read on air, and we cannot give any personalized advice to try to keep it relatively impersonal and thoughts about generic companies or, you know, investing theses and stuff like that. So today's question comes from Mark Frost from the Isle of Wight. And basically he's confounded or bemused was his word at some of the price discrepancies in a lot of companies. And it kind of ties back to what

Starting point is 00:18:52 we were talking about with the S&P 500, you know, six month returns for here. And his thing is AI hardware suppliers, he gives a list of quite a few of them with, you know, price to earnings ratios over 40 and saying their current price is way ahead of fair value. Whereas some of the big software companies and the hyperscalers, Microsoft, Meta, Google, he argues where fair prices are way above current share price and they have these long track records of really good cash generation profits, things like that. And understanding the argument concerns about AI eating into these business models in that each case they own the customer relationship. Basically, he's asking, like, what am I missing here? Is it just herd mentality that we're seeing this wide discrepancy

Starting point is 00:19:34 of kind of like unconventional valuations? Or is this, you know, maybe a dynamic he's not seeing right now? I mean, essentially, he's right that it's herd mentality. I mean, investors are willing to pay a high premium for companies that have high confidence future growth, like Caterpillar, for example, as opposed to tangible cash flow at reasonable multiple, but with uncertain future growth or innovation potential, like Salesforce and Microsoft and those kinds of companies. So in other words, the market is pricing AI infrastructure demand with high confidence and low risk while pricing AI giants with skepticism. Now, to be clear, I don't know if the market's right on either side of that right now. And I, quite frankly, I don't think it

Starting point is 00:20:14 is. There are a lot of AI infrastructure players whose valuations, in my opinion, have gotten a little bit ahead of themselves, but it is hard mentality when you see groups of stocks like those move together. Yeah. The only thing I would say to like the predictable cash flows of the Microsoft's meadows of the world is the operations cash flows are very predictable, but the amount of money they're spending has completely changed. And I think that does change the dynamic in terms of free cash flow, because, you know, we've seen companies like Meta taking on debt. We've even seen Alphabet announce an equity raise because they're basically saying we're going to outspend our operational cash flow in the coming years. So it's not just, you know,

Starting point is 00:20:54 the period where it's like we're throwing off all this excess cash, it is changing the spending dynamic for a lot of these companies. Yeah. To go back to the question, I mean, the first part was essentially herd mentality. And I think we could do a whole episode on herd mentality, quite frankly, because I think that that is a very tangible force in the market. I agree with Matt. And I think that it's going to become even higher in the future. And here's why it's just becoming so much easier to have access to information and to research companies. And so to me, it's only natural that more people would be discovering companies than compared to in the past. You'd look back at Warren Buffett back in the day. I mean, he's flipping through

Starting point is 00:21:36 these booklets on paper, you know, one by one to find ideas. Not a lot of people are going to do that, but with even AI tooling, I can make some prompts and start going down some rabbit holes and discovering some companies. So I think that that will lead to more people discovering things. I think that does increase the possibility of herd mentality. And I will point out that herd mentality isn't necessarily wrong. The herd can be right. And so I want to play devil's advocate right there. And I'll play devil's advocate here too. I mean, you look at Caterpillar stock trading at 51 times earnings. Yeah, that's unusual. It's five-year average down at 20 times earnings. So more than double what it normally trades at. But does it have above average

Starting point is 00:22:16 earnings growth potential on the horizon. And I would say it potentially does there as well. Some analysts are calling for 60% earnings per share growth over the next three years. You can imagine a scenario where in particular it's reciprocating engines. It's looking to triple its capacity to produce those. You could see a scenario where three years and beyond earnings growth even picks up more because business demand is so strong. So maybe those earnings growth do carry it and justify the valuation today. Now, that's not my highest bet for the future, but I am saying if you told me that you wanted to buy Caterpillar stock today at these valuations, I wouldn't think that you were crazy. I think there is some justification

Starting point is 00:22:58 to what's happening. I'll keep my notebook out. I feel like her mentality will be a great either evergreen or one of those ones where we have to pre-record. But that is all the time we have for today. Matt, John, thanks for sharing thoughts. I'm going to hit the disclosure and we'll get ad. As always, people in the program may have interest in the stocks to talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley Fool editorial standards and is not approved by advertisers. Advertisements are sponsored content provided for informational purposes only. To see our full advertising disclosure, please check out our show notes.

Starting point is 00:23:33 Thanks to our producer Bart Shannon and the rest of The Motley Fool team. For John, Matt, and myself, thanks for listening, and we'll chat again soon. you

Motley Fool Hidden Gems Investing - The Challenges of the China Market

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