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Newsletter November 2007
Can’t help but to start
with a quote from the previous Newsletter, saying “Based on our cautious
but still bullish outlook for the U.S. markets, coupled with our strong
outlook for the China stock universe, we think October can potentially be
another great month for China ADR investors”. And indeed, October turned out
to be another great month—only for the smart investor! Chinavestor picked
stock of the month, China Life Insurance (LFC), is trading above $100 vs.
$88 at the beginning of the month. Plus Growth and Conservative Portfolios
(Update on Page5) are ahead 13.8% and 11.0% , respectively. But as the chart for major
indices demonstrates, not all China investors are there to celebrate. The
broader Shanghai Composite Index (SSE
Comp. in red) is
up by a mere 3.5 percent versus the Hang Seng’s 16.4 percent or FXI’s 19.1
percent. Again, U.S. indices were virtually unchanged, the DJIA edging
down 0.3 percent during the same period. What might surprise many is
the weakness in Shanghai. Some may mention China bubble and such but the
matter of the fact is that Petrochina (PTR), the second largest company in
the world by market value as the summary table on page 2 reveals,
attracted about 3.3 trillion Yuan ($440 billion) in subscriptions to its
Shanghai IPO, a record for a domestic stock offer. Petrochina is offering
up to 4 billion A shares to raise as much as $8.92 billion in the offer,
which is expected to be the world’s largest IPO so far this year. The
drain of funds to this huge offer sent short-term Chinese money market
rates soaring to multi-year highs lately and pushed down the stock market.
Liquidity in the markets is expected to improve dramatically on October 30
and November 1, when funds frozen by the IPO are returned to unsuccessful
applicants. If so, expect the Shanghai
Composite and her closest following ETF, Morgan Stanley China (CAF), to
head north in the first days of November. Regarding the overall market
sentiment, we remain bullish for the rest of the year. Main
reasons: 1. Strong GDP growth of 11.5
percent in Q3 translates to strong profit growth, as demonstrated by China
Mobile (CHL), China Life (LFC) or China Unicom (CHU) in
Q3. 2. Access money flooding Chinese
stock exchanges. Think about this: the number of stock investment accounts
in China rose above 100 million by the end of May 2007, with over one
quarter of them opened since the start of the year. Now the question is this: how
to play China under such circumstances. One way looks as if catching
IPOs early is a sure recipe. U.S. investors just can’t seem to get enough
of Chinese companies that come to list in U.S .markets. As the following
chart on this page reveals, each of the six Chinese companies that IPOd
since July has been sold at the high end or above its expected price
range. However there are serious problems with these IPOs. There is no way
to know how reliable their earnings are. We have been following Chinese
IPOs and trading long enough to remember certain shockers. One may recall
Sinovac (AMEX:SVA), a vaccine maker. This biotech company presented a
fabulous growth potential at a UBS sponsored conference in New York; yet
it used proceeds from the
following road show to benefit employees’ pockets through an “employee compensation“ program.
At one point, outflows of such program were larger that any other cost the
company reported. Or another instance was 51job Inc. (JOBS:NASDAQ),
allegedly China’s Monster.com. After the successful IPO and good times for
three months it turned out that the company derives most of its revenues
from print advertisement, positioning itself more of as a yellow page
company. Its stock price tumbled and has been trading under IPO price ever
since. And finally, there has been a lot of fanfare about China’s solar
energy IPOs, projecting triple digit revenue growth rates, but investors’
confidence was seriously shaken after NYSE listed LDK Solar (LDK:NYSE)
acknowledged that the company misstated its wafer inventory. So if you rather play it safe,
yet want to leave room for upside gains, large-cap blue chips offer
outstanding investment opportunities. These stocks offer two advantages
over small-cap China plays: for one their financial disclosures have
proved to be trustworthy and for two, they deliver robust profit
growth. To illustrate how robust their
profit growth is, consider the following facts. China Life (LFC), October
“Stock of the month” at Chinavestor and China’s largest life policy
underwriter, posted a net profit of $1.05 billion on Oct 29 as investment
gains ballooned amid healthy premiums growth. China Unicom Ltd. (CHU),
China’s smaller mobile operator said on Oct 26 that its third-quarter net
profit more than doubled. Chinese internet search
company Baidu.com (BIDU) beat forecasts by more than doubling its
quarterly profit. Its strong search market position sent its shares well
over the $328 mark when we gave it a “BUY” recommendation despite high
valuations. Another expensive stock ICBC,
China’s top lender and the world’s largest bank by market value, posted a
76 percent jump in third-quarter profit thanks to a widening interest
margin and fee income growth on Oct 25. ICBC reported Q3 earnings of 22.46
billion yuan (US$3 billion), compared with 12.8 billion yuan a year
ago. Or take a look at China Mobile
(CHL), the world’s largest wireless carrier. This behemoth posted a
forecast-beating 38 percent surge in quarterly profits as it reported
strong subscriber growth. Profit for the third-quarter totaled $2.93
billion compared to $2.13 billion a year earlier. And finally, Petrochina (PTR)
pumped 4.3 percent more oil and gas in the first nine months of 2007.
Strengthening oil prices bode well for the world’s second largest oil
producer, which said was on track to meet its targets for this year.
Now, let’s put these numbers
into perspective. Apple shares more than doubled this year and set a new
all-time high of 186.16 on Oct. 23. after the company reported strong
earnings. The news set a positive tone for the DJIA as well and the major
index rallied 110 points for the day. Do you remember the actual number
for Apple? Net income was a mere $904 million compared to CHL’s 2.93
billion, for the third-quarter. Another way to understand how
strong Chinese companies became is by looking at their impact on the stock
exchange itself. As the following chart demonstrates, market
capitalization of Chinese exchanges have grown dramatically since January.
If we combined all three major Chinese exchanges, Shanghai, Shenzhen and
Hong Kong, their combined market capitalization would surpass that of
Japan and rival the combination of all of Europe and Britain. And it’s not just market
value. Trading in Chinese exchanges has increased dramatically, resulting
in a similar trend to the market capitalization change. One may ask if the resurgence
of stock market activity is a result of new stocks flooding Chinese stock
exchanges or the high valuation of large cap companies is mostly
responsible for the spike. Regarding IPOs, Chinese
exchanges have welcomed stocks like Alibaba.com in Hong Kong, that raised
$1.5 billion in the biggest IPO offering by a Chinese internet company at
the end of October. Another mega IPO we reported was that of China Shenhua
Energy, China’s largest coal producer. Petrochina is just about to get
started to trade in Shanghai with CNOOC Ltd. (CEO) and China Mobile Ltd. (CHL) in the
pipeline for Shanghai. It looks as if not the number
of IPOs but the quality of IPOs is responsible for such a market activity.
Looking at the chart on the right titled “Number of Listed Companies”
reveals that this assumption is partially right. While the number of
listed companies in China is somewhat increasing, it is virtually flat in
Hong Hong. This makes the case that the number of IPOs alone is not
explaining the increase of market activity in China and Hong Kong.
Another factor that plays a
significant role in the emergence of the Chinese stock exchanges is
valuation. Speaking to many of our
clients, a common concern came up—valuation. We said we preferred
Petrochina (PTR) over CNOOC Ltd. (CEO) in the last Newsletter. We posted a
“BUY” on CHL at $58.09, on LFC at $58.18 or on ACH at $40.92. These stocks
are now up 90 percent on average. Do we still like them? How can we
justify that? It boils down to earnings
growth. Seasoned investors know that a relatively tiny change in revenue
and/or profit growth has a tremendous impact on stock valuation and as a
result, stock price. Reason being that stock valuation is based on the
present value of expected profits compounded over 30 years. A tiny change
in profit growth rate over 30 years has a dramatic impact on present
value. It also means that stocks with
proven strong earnings growth enjoy higher P/E ratios because analysts
believe these companies can sustain high growth levels. And this is
exactly the case with Chinese companies. Take a look at China Life
Insurance (LFC) for example. Stock price for this company is up tenfold
since her IPO, yet P/E ratio is only 15.26 according to Yahoo Finance.
Considering that this company came from a net loss of $450 million in 2001
to a net profit of $2.69 billion in 2006 and accelerating, high stock
price is more than justified. Or take a look at the last chart on this
page where we compare year-to-date stock price change of Apple Inc (AAPL),
China mobile (CHL), Petrochina (PTR) and China Life Insurance (LFC). From
this respect, these Chinese blue-chips are just as expensive as Apple Inc.
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China stock IPOs,
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