Newsletter June 2007

Are Chinese Shares Overvalued? Many started to worry about a China bubble and for good reason. Shanghai’s 130 percent run in 2006 and another 50 percent this year certainly raised eyebrows. Even more so when former FED Chairman, Alan Greenspan warned of “dramatic contraction” in Chinese stocks, fanning concerns about China’s red-hot markets. The imposition of triple the stock transaction tax by the government was the last drop in the bucket. The Shanghai Composite fell 6.5 percent the next day, raising concerns about stock valuation. Chinavestor, being a stock research firm specializing in Chinese stocks, is certainly keen to look more into the valuation of the Chinese stock universe both at home and in China. Based on our findings, we don’t expect the market to crash. Strong corporate profit growth, relatively low interest rates and most of the other factors which have fueled the bull run will remain, so we expect the uptrend in Chinese share prices to continue in the long term. We are of a view that it is too early to worry about a China bubble. Even though Chinese markets have soared in the last two years, the previous five years of lackluster performance should not be forgotten. During those five years China’s economy boomed yet the stock market did nothing but bottome out. We think the current run-up is more like a make up for years of less-than-deserved results. As the previous two charts show, the cap weighted P/E ratio of the Shanghai stock universe is certainly higher than that of the DJIA or the Hang Seng. However U.S. listed Chinese equities or ADRs are in sync with the overall valuation of the 30 Dow components. A detailed breakdown of the 30 Dow components is listed on this page. And while the reading is 17.4 for the Dow, the overall P/E for the wide ADR universe is only 18.0.  Surprised? The second chart on the previous page digs a little deeper. This chart breaks down the Chinese stock universe by markets. And while the overall Chinese ADR universe is trading in step with the Dow, there are notable differences between markets. As the second chart reveals, large cap NYSE listed Chinese ADRs, titled “ADR NYSE”, are trading at 16.4 times earnings, actually lower than the 30 DJIA components. However NASDAQ listed Chinese ADRs are trading at significantly higher valuation, at 58.5 times earnings. And while the overall Hong Kong market boasts a relatively modest valuation, its mainland listed shares, better known as the H-shares, are trading at a premium. Still, Hong Kong listed mainland shares are trading lower than its mainland counterparts. So what does this mean for an American investor? For one; NYSE listed Chinese ADRs are certainly not overvalued. Corporate health of Chinese firms, especially those listed on the NYSE, is very strong with robust earnings, low gearing ratios and operating cash flow growth that exceeded reported earnings growth—all promising signs. For details, please look up a complete breakdown of NYSE listed Chinese ADRs on Page 5. Secondly, at first glance, NASDAQ names seem to be pricey. A detailed breakdown of these companies is listed on Page 4. However, the nature of these companies are commanding a higher valuation than that of the NYSE. Take a look at the dominant Chinese search engine company, Baidu.com (BIDU), for example. While the company is trading at over 100 times earnings at present, market savvy investors recall that the stock has not been trading below that triple digit level too often and its current stock price is actually higher than at its infamous IPO price almost two years ago. The markets seem to have accepted such a high valuation for high growth firms. Thirdly; while Hong Kong and the U.S. are mature markets, Shanghai’s domestic A-shares are just finding their place. An irrational exuberance in China is inflating stock prices. In the near term, there could be a downside for the H-shares given that the domestic A-share market may correct further, but long-term investors could see it as a good buying opportunity. As the following chart of China Eastern Airline reveals, Shanghai prices of triple listed stocks have fallen out of sync from the U.S. and Hong Kong listings. China Eastern Airlines is trading in perfect sync on the NYSE and Hong Kong, see blue and red lines on the chart. However, the Shanghai listing, the green line, is trading at a 50 percent premium! Why? What does it mean? How does it effect one’s U.S. listed Chinese ADRs? Well, this phenomena is caused by two main factors. First, the Shanghai Stock Exchange has been flooded with huge number of first-time investors with access liquidity. Secondly, Chinese domestic stock markets are still closed for foreign investors thus excluding price-balancing arbitrage traders. The price asymmetry of the same stock in different markets not only reveals the nature of the Chinese domestic investment climate, e.g. how closed it is for westerners, but also gives us an indication of where  Chinese domestic liquidity goes. This information might become rather important because local Chinese should know well where to put money and also it indicates where the money is going. As we all know, successful investing is anticipating the anticipation of others. From this respect, we should keep a close eye on mainland Chinese investors since they are driving access liquidity to the markets. For U.S. investors, we should look into the valuation of each stock and see if it reveals any opportunity. As the table on this page shows, the NASDAQ listed Chinese ADRs are trading at high valuation, 58.5 times earnings on market cap weighted average. This valuation casts a shadow over all other markets. Well known names such as Baidu.com (BIDU) or Home Inns & Hotels Management Inc. (HMIN) boast triple digit P/E ratios. Also, liquid companies like Sina Corp. (SINA), Ctrip.com International (CTRP) and Focus Media Holding LTD. (FMCN) are lifting overall valuation for NASDAQ names. However Elong Inc.’s (LONG) high triple digit valuation seems irrational. On the contrary, NYSE and AMEX listed Chinese ADRs are trading at a discount compared to the NASDAQ listings and are on a par with the mature Dow components. Looking at individual stocks, China South Airline (ZNH) may seem overvalued at current triple digit P/E, but investors have to consider the fragile financial performance of the airline sector in general. ZNH reported negligible profits, still better than that of the other airliner CEA that is still in the red. 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. In general, NYSE listed Chinese ADRs are trading at rational valuations and offer good investment opportunities. We have liked energy stocks, Yanzhou Coal (YZC) in particular in the past and continue to like diversified oil companies like PetroChina (PTR) or Sinopec (SNP) and transportation company Guangshen Rail (GSH).  We highlight the performance of our “Stock of the Month” recommendation in this context. Not only did Yanzhou Coal (YZC) yield double digit gain during its short tenure but Sinopec’s 22.5 percent gain in the month of May  is the icing on the cake. And finally, we should not forget the AMEX listed Chinese ADRs. They represent a small portion of the overall Chinese ADR portfolio and are often neglected. For us, they represent a set of stocks that are somewhat in the high risk/high return category as Sinovac’s (SVA) volatile stock price demonstrates.  To access latest Newsletter and other research content, please register!