Newsletter November 2006

Investing in China Has Never Been More Secure   While the premise of this article may be surprising to many, e.g. investing in China has never been more secure, the emergence of the Chinese markets is real, and recent events strongly support this premise. Who could have predicted only a short time ago that the IPO of the Industrial and Commercial Bank of China (ICBC)  on October 27 would draw a record- breaking demand for a public offering? The ICBC offer tops the US$18.4 billion float by Japanese mobile phone operator NTT DoCoMo in 1998 and the process could raise nearly US$22 billion if an over-allotment option is exercised in full. The strong showing reflected the keen interest of foreign investors in cashing in on emerging opportunities in China. “This is the world’s largest IPO ever with the biggest subscription rate. That speaks volumes for the quality of the offer and for global investor confidence in China”, said Damian Chunilal, president of Pacific Rim Global Markets and Investment Banking at Merrill Lynch, one of ICBC’s underwriters. While the ICBC IPO is a noteworthy event, it is more significant that China has shed its previous reputation as a risky developing country and is now regarded by many as a golden opportunity with a more and more stable investment  environment. And just how quickly things have changed: the official Chinese news agency, Xinhua, reported on May 30, 2006 that “ICBC, China’s biggest lender in terms of assets, could raise about US$12 billion in an initial public offering ahead of its listing on Hong Kong later this year…ICBC Chairman Jiang Jianqing said one week ago that he expected the bank, by stock market value, to become one of the world’s top 10 banks…”. In contrast to those earlier expectations, the successful IPO propelled ICBC into the top five banks by market value, behind JP Morgan Chase &Co and ahead of Mitsubishi UFB,  and the IPO raised just under US$22 billion. At this point let us refer back to our October newsletter of 2005, in which we published a study of the Chinese banking sector titled “Scramble for China’s bank market”.  That article drew attention to the Chinese banking sector. We pointed out that valuations were extremely attractive a year ago as the coming IPOs were priced 1.29 to 1.87 times their book value for 2005.  It is not surprising, therefore, that Bank of Communications trades 132 percent above its IPO price, while China Construction Bank and Bank of China are up 50 percent and 13 percent, respectively. ICBC’s IPO values the lender at 2.23 times its forecasted book value. By comparison, No. 2 mainland lender Bank of China traders at 2.35 times 2006 book, No. 3 China Construction Bank trades at 2.66 and No. 5 Bank of Communications trades at 3.04 times book. From this perspective, ICBC’s share sale was a bonanza for foreign institutional investors led by Goldman Sachs, which paid US$2.58 billion in April for about US$16.5 billion ICBC shares — a stake that is now worth US$7.45 billion. Allianz and American Express also bought stakes alongside Goldman that are now worth a combined US$3.5 billion. Individual investors can say: it’s all good that institutions made a killing in China but how can I benefit? What are the stocks to buy? Why was this IPO so outstanding and what does it imply as to the future?  The reason why this IPO was so hot was best captured in the following pronouncement: “Investors foresee China’s economy maintaining 10 percent growth every year before the 2008 Olympics in Beijing, so investors are buying mainland bank shares now to access that growth,” said K.C. Chan, executive director at money management firm KDB International.* So the world is betting on China’s growth now. And so do we. We think liquid, big names from the NYSE listings will do well in the upcoming years. We have liked and we are  still in favor of the following big names. China Mobile (CHL)  for its  solid subscriber growth and strong balance sheet, China Life Insurance (LFC)  for outstanding money flows and institutional interest,  HSBC Bank (HBC)  for its solid fundamentals and PetroChina (PTR)  for its diversified petroleum exposure coupled with extremely strong balance sheet. We highlighted these stocks in the “Stock of the Month” section at the end of the newsletters and they shined! NASDAQ names are much harder to predict for a number of reasons. First, institutional investors are exercising caution when it comes to NASDAQ names. The lack of such players makes stock prices much more volatile and unpredictable. Second, the nature of the business most NASDAQ names operate in have experienced sporadic growth. We have been following 51jobInc. (JOBS), Shanda Interactive (SNDA) and NetEase (NTES) just to see sky-high earnings in one quarter and huge disappointments the next. Third, even if a company reports strong growth, valuations can run out of sync with reality. High valuation then makes price prediction more difficult. Since we have the China hype in one hand and high valuation in the other hand. Baidu.com (BIDU) is a good example of this phenomena. The internet search company has been delivering outstanding top and bottom line growth yet sky-high valuation makes it irrational to predict the future stock price. Or Ctrip.com (CTRP) is another example of delivering strong results yet high valuation makes it difficult to justify additional stock price appreciation. Going back to the big picture, e.g. investing in Chinese stocks has never been more secure, we have another indicator to look at. Looking at the major indices of the most liquid Chinese stock market, Hong Kong, and the Dow from a historical perspective, let’s say 20 years, reveals an interesting story. The chart above clearly shows that correlation exists between the two indices and while the market is more volatile in Hong Kong the direction of the indices are the same. “Actually, the correlation between the DJIA and the Hang Seng is 0.89”** In other words investing in Hong Kong is more risky because of market volatility but over time returns are the same. And this is big news for risk averse investors because investing in quality Chinese companies is nearly as risky as picking a NYSE name.   Shanghai Stock Market to Take Off Soon   Chinavestor long term clients may recall that we have published a similar article in this year, “Mainland Exchanges Poised to Explode” in March 2006. In that article we have argued that the time has come when GDP growth will transform into stock market appreciation as well. And times proved us right as Hong Kong blue chips hit a new record with H shares at 9 year peak as we speak. Also the Shanghai Composite  hit a five year high on October 27 just a few days ago. The reason of the article is not to boast about our track record but rather to add additional information to this fact. Based on estimates published by Credit Suisse, the equity value of the Chinese mainland capital market will surge to 1.8 trillion U.S. dollars by 2010, as more overseas-listed state-owned companies choose to go public at home. The aggregated value of China’s renminbi-dominated A-share and foreign currency-dominated B-share markets stood at 660 billion U.S. dollars on October 3. Credit Suisse’s prediction means that the two market’s equity value will hit 50 percent of GDP in 2010 versus 18 percent in 2005. Looking at the expansion of stock markets in other  countries such as Russia, the Republic of Korea and Thailand in the last two years, we think this forecast is conservative. The forecast puts Chinese comparables lower than the world average and that of most emerging countries. Given the unprecedented IPO of ICBC combined with other state-owned enterprises such as Bank of China and Datong-Qinhuangdao Railway going public in the last quarter, we are more optimistic about the Chinese stock market performance. Considering China’s rapid economic growth, adequate domestic capital supply and the constant improvements in the stock market system, we think China will do better. Looking back the ICBC IPO was the first simultaneous Hong Kong and mainland China listing making inroads for others to follow. And while the IPO attracted share orders worth about 400 billion U.S. dollars for the Hong Kong portion of the deal, the domestic  listing received only about  780.7 billion yuan (99 million U.S. dollars). But the phenomena of Chinese companies opting to list in domestic markets is obviously  coming. For more on this issue,  we urge our subscribers to look up Chinavestor’s 2006 February Newsletter and look up article “Foreign listed Chinese companies to apply for mainland listing”. In that issue we drew attention to the phenomena that Chinese state-owned companies are more in favor of going listed at home exchanges than going public on foreign soil. Chinese regulators are trying to list quality companies on home exchanges to improve those exchanges. The improving domestic capital supply plays a big part of this process. Based on estimates, around 93 billion U.S. dollars will be raised on mainland bourses in the next five years. There are 53 local companies whose equity value  exceeds three billion U.S. dollars each. Twenty-nine of them have gone public overseas, posting an aggregated value of 731 billion dollars. Should these companies list on the A-share market, the equity value of the A-share market would approach 1.4 trillion dollars. Right now opportunities on the mainland capital market mainly concern large state-owned enterprises. But the biggest cash cow is the banking sector whose profits will rise further as they engage in a broader range of financial activities. Over time the largest system defect in China’s stock market is disappearing as shareholding reforms convert non-tradable shares into tradable shares. Now that over 1,000 Chinese companies listed on the Shanghai and Shenzhen stock exchanges have completed the reforms, China’s stock markets are booming. Hong Kong blue chips hit a new peak, H-shares at a 9-year high and the Shanghai Stock Exchange closed at 1855.71 on Wednesday, a new high.     To access latest Newsletter and other research content, please register!