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Newsletter October 2007
The last trading day of
September was a happy one. Our favorite proxy for the overall China ADR*
universe, the iShares FTSE/Xinhua China 25 Index (FXI), closed at $180.00
marking an exact 20% run over the month. What makes this rally even
more remarkable is the strong underlying volume. We know that Hong Kong is
the home market for the most prominent FXI components. So we found comfort
in the news that Hong Kong blue chips rose 0.3 percent amid unprecedented
volume on Friday,
September 28th, closing out the quarter with their best gain since the end
of 1999. The Hang Seng Index gained 13.6 percent for the month and 24.7
percent for the three months ended in September. Hot money from the mainland
poured into the Hong Kong Stock Exchange ahead of more Chinese
institutional funds. According to Rita Chang from Reuters “JPMorgan said
in a note that mainland institutional investors qualified by Beijing to
invest in overseas securities were unlikely to be accumulating Hong Kong
stocks at the moment, given their rapid rise.” The Hang Seng Index hit its
seventh straight record at 27,255 before closing up 77 points at
27,142. Naturally, investors would
think that this unprecedented momentum will carry over to New York and
propel NYSE listed Chinese ADRs throughout the trading day.
This assumption held true only
until 10:00 A.M. when mixed news sent the DJIA heading south. This slight
change in the Dow made a dramatic impact on the China stock universe, just
as the following chart suggests. While the DJIA lost only 45 points or 0.3
percent, the FXI tumbled 2.2 percent. If anyone had thought that Chinese
ADRs are somewhat immune to the Street, it was a bitter
lesson. If we want to understand what
strategy to follow with our China stocks, we have to ask: where is the
Street heading from here? My feeling is that we have
seen the lows. Despite all the bad news
coming from the home front, I find great comfort in the consumer spending
report. According to the latest update, released on Friday the 28th,
consumer spending was up 0.6 percent in August, the fastest growth in more
than two years. According to the University of Michigan report, consumer
sentiment remained strong. I can not overemphasize the
importance of this news. Consumer spending accounts for two thirds of
total economic growth and as long as consumers are optimistic, e.g. spend,
economic recession gets swept to the side. Another positive piece of
information we noticed was that core inflation seems to be under control,
keeping rate cut hopes alive. We all remember September 18, when a
half-point cut by the FED propelled the DJIA to surge 335 points—its
biggest one-day point jump in nearly five years. According to the FED, banks
slowed borrowing from the central bank, a positive sign that the prospect
for a liquidity crunch is easing. On the negative side though,
credit markets still don’t appear
to operate normally. Also the weak dollar pushed commodity prices
higher, leaving companies with two bad choices. Either they pass on price
increases to the consumer fueling inflation, or they swallow higher prices
thus lowering corporate profits. Neither of them is good for the stock
market. In the midst of these mixed
signals, the bulk of third quarter earnings will start pouring in around
mid October, giving investors a better idea where the markets will be
heading. Until then we share the view
of a respected friend, mentor and former employer, Laszlo Birinyi. In a
recent 2007 September interview with Louis Rukeyser’s Wall Street, Laszlo
is candid about being unsure regarding the short run, though he remains in
the bullish camp for the long haul. He says, “The economy, by most
measures, is still on track. And while it may not be as robust as we
expected six months ago, I see a lot of economically sensitive stocks
still doing fairly well.” Based on historical data,
China stocks do well when Wall Street is strong. As the following chart
demonstrates, there is an obvious correlation between Hong Kong’s Hang
Seng Index and the DJIA. Strong corporate earnings have been fueling China
stocks more than their U.S. counterparts, but the overall pattern
similarity of the two indices
is obvious. 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. We expect strong corporate
earnings to continue for our closely followed Chinese stocks list. Strong
earnings coupled with ample liquidity in Shanghai and Hong Kong are a sure
recipe for another outstanding month. But be prepared for some
hiccups along the road. Strong bullish runs are always followed by
short-term profit takers, and should profit-taking take place amidst some
negative U.S. sentiment, be assured of significant index
volatility. As we just described, Chinese
equities are not immune to events unfolding in the U.S. As the chart of “Market cap weight of global
equity market” on this page suggests, the shear weight of U.S. capital
markets dominate global markets. As a consequence, the saying of “If the
U.S. sneezes the world catches a cold” remains very
true. So one may ask: when will, if
ever, China stocks have a life of their own? We are not in a position to
tell this. However we are aware of a couple of factors that are worth a
closer look. We know that the Shanghai
Stock Exchange has ample liquidity. The Shanghai market just
surged to a fresh record high on September 28, as billions of yuans which
had been frozen by a large equity offer returned to the market. The
Shanghai IPO of China Shenhua Energy earlier in the week was massively
oversubscribed, attracting a record 2.66 trillion yuan ($355 billion) in
subscriptions. The liquidity factor is instrumental to make a difference
in the life of a stock exchange. Having no real investment vehicle in
China, other than low yield bank deposits or the stock market, investors
have been pouring tremendous amounts of money into the Shanghai and
Shenzhen stock exchanges. As a noticeable consequence,
prices in Shanghai broke loose from those in Hong Kong and the rest of the
world, creating the A-share H-share price mismatch; a notion that our
September Newsletter tackled. Since that issue became public, significant
events have unfolded. The class of Chinese domestic institutions and
investors, who were thought to be eligible to invest in Hong Kong, are now
limited to individuals, significantly controlling capital outflows. As a
result, we think the current A-share H-share price difference will persist
for some time. But again, the fact that the
price of Chinese equities in different markets went in different
directions signals some of the potential strength the Shanghai Exchange
can embrace. Another factor in determining
if Chinese equities have a life of their own is how China’s economic might
plays out. Right now export represents a very substantial proportion of
economic activity. The latest data put China’s industrial sector at around
52 percent of its GDP, well in excess of the 32 percent share of a
developed nation. We expect that this will
change. As the purchasing power of the average Chinese improves, partially
propelled by a strengthening yuan, Chinese domestic consumption will take
over from export, making the country and her exchanges more resilient to
global economic cycles. It’s hard to argue that a stock market in a
moderately well off China with a population of 1.3 billion will not be
able to run her own cycles. But before that happens, if
ever, we want to highlight stocks that are of interest
now. We picked China
Southern Airlines Ltd. (NYSE:ZNH) to be “Stock of the Month” in
September, and the stock did not disappoint. From the price of $63.00 she
rallied up to $94.48 just to come back and close the month of September at
$77.01, marking a 37.5 percent gain from month to month. But we think the
stock will get worse before it gets better. There has been ongoing
industry restructuring rumors and actions, most notably Singapore
Airline’s alleged investment in China
Eastern Airlines Co. Ltd. (NYSE:CEA) that created the buzz. But at
the end of the day, both ZNH and CEA came down fast as a major industry
revamp is out of favor and we think the slide will continue for the time
being. In other words, we don’t recommend taking a position in any of the
Chinese airlines right now. What we like instead are
cyclical stocks. As we argued, the weakening dollar pumps profits of
companies like Aluminum
Corp. of China (NYSE:ACH)
and
Yanzhou
Coal Mining Co. (NYSE:YZC).
These stocks have
performed extremely well year-to-date and we think the rally is not over
yet. The telecom sector has made a
remarkable rally from the second half of September. China
Mobile Ltd. (NYSE:CHL) has been our long time
favorite, securing places in both the Conservative and Growth Portfolios
since June, 2006. Given her robust earnings, China Mobile is still
attractive at current prices. High oil prices boost earnings
of both PetroChina
Co. Ltd. (NYSE:PTR) and China National Offshore
Oil Company or CNOOC
Ltd. (NYSE:CEO).
Not surprisingly, stock prices of both oil majors are at record highs but
they can become volatile should oil future prices come back to the $70
levels. PetroChina looks somewhat more appealing at the moment as she
received approval for a domestic Shanghai IPO on September 24, suggesting
more liquidity will pump prices higher. Asia’s largest oil refiner,
China
Petroleum and Chemical Corp. or Sinopec (NYSE:SNP) is adversely effected by high
oil prices. Even though Sinopec boasts substantial oil production of her
own, high oil prices don’t make up for the losses the company has to
endure on the refining arm. The problem is that Sinopec is caught between
low state-set gas prices and record crude prices. As a result, Sinopec is
trimming the fuel flow to markets as much as possible without raising the
anger of the government. Another stock we like is
China
Life Insurance Co. Ltd. (NYSE:LFC). The company delivered better
than expected earnings, showed no sign of slowing down and is the industry
leader in her field. The only thing on the negative side was her two month
fall at the beginning of 2007. This stock is a hot commodity and has been
very sensitive to short-term market corrections. However history shows us
that this stock follows a dip with a quick recovery. Therefore we think
this makes her a good long term play. Venturing over to the NASDAQ
listed China stock universe, we have Baidu.com
(NASDAQ:BIDU) and
Ctrip.com
(NASDAQ:CTRP) in
the Growth portfolio. While Ctrip.com rewarded
investors with 27.6 percent return in the month of September, her
performance is overshadowed by Baidu.com’s staggering 45 percent!
It is getting more and more
difficult to argue for the rational valuation of Baidu.com. She is trading
at 172 P/E according to Google Finance, yet conventional wisdom sometimes
is not enough to understand it all.
Forward P/E for Baidu.com is 57.50, not too far from Google’s 32.66. And remember, Google’s P/E
ratio exceeded 100 during the summer of 2005 when the stock was trading at
low $300s. Google’s current price of $567.27 explains it
all. Crip.com is another stock we
have liked and continue to like. Valuation is getting a little tricky over
here, too but we think the company will deliver another strong quarter,
making high stock prices justified. And here we want to refer bck
to the June 2007 Newsletter, article “Are Chinese Shares overvalued?”. In
that piece we argued that while NYSE listed China ADRs are trading at
relatively low valuation, actually in par with the P/E for the overall
DJIA, the NASDAQ listed China
ADRs are trading at much higher P/E, making them susceptible to a sizeable
correction should market sentiment change. Again, investors have to be
very selective when picking from the NASDAQ names. To access latest Newsletter and other research
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China
stocks in the shadow of Wall Street
