Newsletter July 2007

What keeps Chinese stocks rising? Despite all adversaries, we believe that Chinese shares available for U.S. investors are modestly valued and offer outstanding trading and investing opportunities. Well, from a Chinese stock advisor, it sounds as a mandatory statement. But here is the back up of the statement. There are three distinct forces that have propelled Chinese equities among the best performers in 2006 and 2007 so far. And as we'll see, these forces are not about to diminish any time soon. And as long as these factors prevail, we are bullish of the overall Chinese equity markets. So let's see what these factors are: Strong fundamentals, such as earnings Excess money flooding Chinese exchanges Yuan / $ U.S. exchange rate change. Let us examine them a little closer. China, the world's fourth largest economy, is now seen expanding by 10.6 percent this year after last year's 10.7 percent rise, buoyed by booming domestic demand and resilient exports. According to data provided by Reuters, analysts predicted the economy would expand by 10 percent this year and slow slightly in 2008. This would mark China to post a sixth straight year of double-digit growth. For investors however, what’s even more important,  China is not only a growth story, but a profit growth and margin expansion story as well and one of improving return on equities, high dividend yields and payout ratios. Educated global investors, who appreciate the solid fundamentals supporting current stock prices, are still bullish and believe there is more room for Chinese equities despite strong gains recently. Take a look at China Mobile (CHL) for example. The company boasts and outstanding  balance sheet with strong cash position and high liquidity. The company’s got more than enough financial muscle to expand into rural China and tap into the potential of 600 million additional customers to its current 300 million strong subscriber base. Yet, the company is trading at 25 times earnings, slightly above the industry average of 22.7. And again, NYSE listed Chinese equities are trading at modest valuations as we argued in the pervious Newsletter by looking at each company individually. Second factor to watch is money flows. We have started to argue that Chinese stocks are moved primarily by news and investors based in China and not in the U.S. As the chart on this page shows, dollar volume of the same stock on the NYSE is always the lowest. We all remember when Hong Kong listed H-shares jumped this month on news of changes to China’s qualified domestic institutional investor scheme, which allows Chinese institutions, e.g. banks, to invest assets overseas subject to a quota limit. This is news, since the proportion of assets that could be invested in overseas equities is increased to 50 percent of the shares of Hong Kong listed Chinese companies, especially those which also are trading in Shanghai and Shenzhen. Even though the quota is now only $15 billion, it signals a fundamental shift. A forthcoming creation of a State Investment Company which is believed to have a portfolio value in excess of $100 billion is likely to have a far greater effect. A second pool of money comes from individual investors. Given the limited choice of investment engines, ordinary Chinese have discovered capital markets as an alternative to low yielding bank deposits. Last year’s triple digit growth of the Shanghai Stock Index coupled with this year’s 50 percent in addition keeps attracting over 300,000 new investors a day. This stock market frenzy is further fueled by regulatory changes. In an effort to promote the Shanghai exchange, Chinese regulatory authorities have suspended approvals  in the middle of June for many private companies to list on overseas stock markets.  In addition to this, China’s market watchdog has drawn up rules to allow non-mainland registered, Hong Kong listed domestic firms—known as red chips— to list on the country's domestic exchanges, clearing the way to the long-waited listings by firms from China Mobile Ltd. (NYSE:CHL)(HKEx:0941) to CNOOC Ltd. ()NYSE:CEO)(HKEx:0883). These changes are not only helping the development the country’s capital markets but just as importantly give local investors a broader range of stocks to trade, further fueling the frenzy. Most of the big-cap red chips are state-owned enterprises (SOEs) that have completed share-restructuring reforms. Since the securities reform of the mainland stock market, Shanghai has seen H-share large-caps, such as the Bank of China and the Industrial and Commercial Bank of China, listed on the mainland exchanges. As a result, the combined market capitalization of SOEs and big financial firms account for 60 percent of the total market capitalization on the Shanghai and the Shenzhen exchanges. This notion, e.g. foreign-listed blue chip Chinese firms seeking mainland listing, boosts sentiment for H-shares, or Hong Kong listings, because the A-share valuation will be much higher than the H-share valuation. For foreign investors, Hong Kong’s stock market is the main way to play China’s booming growth story. But China’s closed markets and lack of investment choices mean Shanghai shares trade at a huge premium to those of the same firms listed in Hong Kong. An excellent graphical representation of this phenomena is seen on the right, chart titled “Hang Seng China AH Premium Index”, compiled by the HSI Services Ltd., manager of Hong Kong’s benchmark Hang Seng Index (HSI). About the Hang Seng China AH Premium Index: “In view of the prevailing price difference between the A shares and the H shares of AH companies, the AH Premium Index is compiled to meet the demand for an indicator of the overall price difference between the two classes of shares. The index is designed in a way that the higher the index, the larger the premium of A shares over H shares, and vice versa. When A-share prices are at par with H-share prices on average, the index will be at 100. As at June 27, 2007 the AH Premium Index closed at 146.73, meaning A shares are trading at an average premium of 46.73% above H shares. A detailed breakdown of the 27 constituents of the Hang Seng China AH Premium Index is provided on  page 3. As a result, investors have pondered ways to make money from the wide price gaps between the A and H shares, but that is unfeasible in the short term because China’s exchanges are walled off to all but to a few selected foreign firms. And finally, the third factor helping the Chinese equity markets is the Yuan/dollar exchange rate. To be precise, not the current rate but the anticipation of further Yuan strengthening against the greenback. The expected Yuan strengthening translates into share price appreciation in U.S. dollars, giving foreign investors an artificial incentive to play Chinese stocks. As a result, not only Chinese domestic money is boosting stock prices but also funds from international flows contribute. Let’s see how it works. When a foreign investor buys a NYSE listed Chinese stock, or actually a depository receipt, the price he/she pays in U.S. dollars equals the price what an investor has to pay in Hong Kong dollars in the overseas market. Let’s forget Shanghai prices for now as there is an artificial price asymmetry we just mentioned in the previous paragraph. And as the following chart on the right suggests, prices in Hong Kong correlate very closely to that of the NYSE. The blue line represents the NYSE listing while the red line is the Hong Kong listing. Now, if the Yuan appreciates against the dollar, the Yuan denominated earnings of a company translates into more earnings in dollars as the Yuan buys more dollars. With that said, the dollar stock price in the NYSE will rise while the Yuan price will remain the same. We have long heard of the Congress threatening the Chinese to impose a special tax on all Chinese goods unless Beijing agrees to strengthen the Yuan significantly. It’s hard to tell when and how the Yuan will appreciate however we think a 20-25 percent appreciation over the course of five years is plausible. If that takes place, U.S. investors will enjoy a 20-25 percent ride on all Chinese shares. So there are a lot of incentives to play Chinese stocks. But to actually enjoy the ride, investors have to listen to what we say. I recall a subscriber saying that he did not buy the stocks we suggested simply because there were so many rumors on CNBC and other major media outlets regarding the Chinese stock bubble. So he is waiting until the dust settles and then will buy. The problem is that in the process he missed out on Yanzhou Coal’s (YZC) over 10 percent ride and then Sinopec’s (SNP) another 20 plus percent ride. And these are just the most featured stocks we highlight, the 'Stock of the Month' stock picks. And I did not mention stocks from the Conservative and Growth portfolios yet. How about Baidu.com (BIDU) now at $167.89 when it was $140.49 a month ago? Or PetroChina (PTR) at $148.68 vs. $129.24 last month? Even better, we highlighted Chalco (ACH) in the last Newsletter on page 4 saying 'In contrast to the airline sector, strong performance with quality earnings improved the P/E ratio of Aluminum Corp. of China (ACH) and China Life Insurance (LFC). Both are industry leaders in their respective field and are trading at single digit times earnings. This relatively low valuation makes these stocks attractive at current prices. ' If you had bought ACH at $33.01 then, you’d be happy with the appreciation  of the stock price to $42.70 now. Hope you all did. To access latest Newsletter and other research content, please register!