Newsletter  September 2007

Outlook: Autumn 2007  Hope you had steel nerves in August. Referring back to the main article in our previous Newsletter, “Strong stomach needed”, we could not have timed that article better. August turned out to be a heck of a month. U.S. subprime problems put pressure on equity markets globally, sinking our favorite proxy for U.S. listed Chinese stocks, the FXI, 15 percent by Aug 16th. Then the FED’s decision to lower inter-bank lending rates by a half point sent our benchmark up 20 percent by Aug 27th, just to see those gains evaporate the next day. Still, investor optimism fuelled the index to a 7.43 percent gain for the month, attributed to further rate-cut hopes and news that the U.S. governments would help tackle the subprime mortgage problem. The five day FXI and DJIA snapshot below illustrates how the dramatic evens unfolded. The potential problem is bigger than it may seem from the first glance. Investors have to realize that  consumer spending is at stake, which is the biggest contributor to our economy. Should major banks go belly up because of improper lending practices, lending will be far more expensive, hurting the already weak housing market. No wonder, President Bush and FED Chairman, Mr. Bernanke, both acted promptly. Acts that just don’t happen too often. We hope their efforts will succeed and keep the U.S. from plunging into recession. As stock advisors, we can’t do much about this problem. We just highlight that it is far from over and thus investors have to exercise extreme caution in the upcoming months. Prepare your stomach for a bumpy road.   However, the subprime problem is only part of the equation. Another factor we have to watch is the A-share H-share asymmetry. Before we get into stock specific, let’s just take a look at the Chinese stock landscape and examine the phenomena from there. As the following table shows, Chinese shares are listed in multiple exchanges; Shanghai, Hong Kong and New York. During the period of 1993-2000, several dozen Chinese firms offered two classes of shares in Shanghai: class A, which could only be held by domestic investors, and class B, which could only be held by foreigners. Despite their identical rights, A-share prices are trading with an average premium of 86% over B shares. This non-fundamental component in stock price is explained by the tremendous money flows  A-shares enjoyed due to lack of investment alternative for ordinary Chinese citizens and domestic funds. Besides Shanghai, some hundred-fifteen companies ventured into Hong Kong issuing H-shares, tapping into the liquidity and excellence this exchange on the former colony had to offer. Interestingly, Hong Kong is regarded as foreign territory for mainland Chinese, thus money flows freely between Hong Kong and the rest of the world, but the Hong Kong stock exchange remained closed for mainland investors. As a result, strong money flows stopped in Shanghai and did not propel Hong Kong listed H-shares as it did in Shanghai. As a consequence, a price asymmetry between A-shares and H-shares occurred. This gets really interesting for U.S. investors with primary access to the NYSE and NASDAQ, another foreign territory for the Chinese, where over sixty Chinese companies are listed. From investment point of view, the Hong Kong Stock Exchange is closer to any of the U.S. Exchanges than to Shanghai. As a result, U.S. listed Chinese companies, those that happen to be listed in Hong Kong and the U.S. simultaneously, are  trading parallel to each other, creating a price asymmetry similar to that of between A-shares and H-shares. The dramatic change came on August 20th, when China implemented a new policy allowing mainland residents to invest directly in Hong Kong stocks. The prospect of a fload of Chinese cash entering Hong Kong’s financial markets has helped propel large gains in the Hong Kong-listed shares of mainland companies. From August 20th when the announcement was made to August 29th, the Hang Seng Index (HSI) rose 12.92% to 23.021, even though it was adversely affected by the subprime mortgage crisis. The Hang Seng China Enterprises Index (HSCEI), or the index of the H-shares, increased by 14.41% from 11.964 to 13.689. At present, the scheme of direct investment by mainland residents in Hong Kong stocks is still in its trial stage, with Tianjin the first city that operates account openings and gradually, it will be expanded to 40 cities. However, the first trading will not start until September. Up to August 27th 2007, there had been over 2000 registered accounts and over 5000 investors who inquired about the details. The great popularity of this new investment opportunity indicates a future large volume of funds flowing to Hong Kong.  As a result, prices in Hong Kong, similar to that in New York, will catch up with prices in Shanghai. This price adjustment is not expected to be a one-way road though. Prices will have to come down in Shanghai and go up in the rest of the world, so they can meet somewhere in the middle. Let’s call this price “equilibrium price” for the rest of the Newsletter. The problem with the middle is that no one can tell where the middle is going to be. We are going to give investors an educated try but again, there is no way anyone can predict equilibrium price with 100 percent accuracy. We will consider two major factors that are instrumental as to where the prices will settle. Money flows for one and current A/H Price Ratio for two. Regarding money flows, investors have to realize that for Chinese stocks, most often Shanghai and less often Hong Kong is the home market. This is where most of the liquidity comes from. New York plays a minor role in Chinese stock money flows. As the table on the next page reveals, liquidity—a close proxy for money flows—is strongest in Shanghai for all stocks except China Life Insurance. Looking at the fourth column, “Average Daily Dollar Volume”, it is clear that Shanghai is the dominant market. And just how dominant it is will have a strong say in the price adjustment process. The equilibrium prices are more likely to gravitate towards Shanghai prices because of its stronger money flows. Looking at the table on this page, China South Airlines, Guangshen Railways and Aluminum Corp. of China are most likely to gravitate towards Shanghai prices where as Yanzhou Coal and Huaneng Power are less affected by Shanghai prices. The second factor we think is instrumental in determining equilibrium price is current A/H price ratio*, or the last column in the table. Using common sense, the higher the A/H ratio, the bigger the gap between Shanghai and Hong Kong prices. From this respect, Sinopec Shanghai Petrochemical, Aluminum Corp. of China and China South Airlines offer the best trading opportunities, while China Life Insurance, Guangshen Rail, and Yanzhou Coal Mining look less attractive. Combining these two non-fundamental factors, we think that China South Airlines (NYSE:ZNH), Aluminum Corp, of China (NYSE:ACH) and Guangshen Rail Co. (NYSE:GSH) are the best suited for taking advantage of the current situation. These companies are trading by a large gap between different exchanges and are strong enough in their home markets to gravitate towards the higher price. And finally, we always watch the fundamentals. The period for companies to report earnings for the first half of this year ended on August 31, with combined net profits up 70 percent from a year earlier, well above analysts' forecasts just a month or two ago. A poll we came across of 10 fund managers and securities analysts found that they had doubled their forecasts for second-half profit growth to 50-60 percent, from 25-30 percent predicted in a late April poll. As one analyst put it, “Earnings were above most analysts' expectations, and companies which announced outstanding first half-earnings will attract more money in coming weeks". As a consequence, we expect the very strong earnings growth to continue to the rest of 2007 so the market's uptrend will not change. And more importantly, strong earnings growth will keep Shanghai valuations at bay, pushing Hong Kong and NYSE prices towards their higher peers.