A near 20 percent correction in the Chinese stock universe in January marked the worst month for Hong Kong equities since Oct. 1997 as rising risks of a U.S. recession prompted a global equities sell-off. As the following chart suggests, the Hang Seng Index of Hong Kong lost 15 percent in January alone. U.S. listed Chinese stocks did not make it any better as the broad China ADR Index or CAI lost 14.7 percent, too.  U.S. stocks held up better, sending the DJIA down 4.9 percent for the month to  12,650. To make matters worse, ratings agency Standard & Poor's said it cut or may cut its rating on up to $534 billion of subprime bonds. Where is the bottom? Where do Chinese ADRs go from here? 

Well, at least we were right saying in the January Newsletter on page 3 that “If history is any good predicting future, NYSE listed Chinese ADRs are the way to go in 2008”. And while Chinese equities listed on the NYSE lost a significant 14.5 percent, NASDAQ listings suffered even more, finishing down 19.9 in January. Not that it makes us any happier but at least some of our advice paid off even in dire market conditions.

The free fall was almost universal with the exception of the telecom sector. Under the restructuring plan, China Mobile (CHL), the world's biggest mobile telephone operator, would merge with the national railway's fixed-line unit, China Tietong. China Unicom's (CHU) GSM mobile business would join with China Netcom Group while China Telecom Corp (CHA), the country's top fixed-line operator, would acquire Unicom's CDMA mobile telephone business. This industry reshuffle along with the planned launch of China’s home-grown 3G standard TD-SCDMA before the Olympics created buzz in the industry, benefiting primarily China Unicom and China Netcom. 

Still, it is a far outcry for diversified China stock investors who lost their shirt on energy, basic materials, and internet related stocks. What happened?

We’ll use the same structure that we laid down in the previous Newsletter, to look at each important factor determining stock prices.

We said that “analysts continue to be cautiously optimistic about Asian economies”. This still holds true. Asian economies are as strong as they have ever been. Almost all Asian economies operate under huge current account surpluses, ample foreign reserves and are experiencing fast growth. 

As an indication of this, let’s step back for a moment. In the midst of the current financial crisis in the U.S. the best American companies, from Bearn Sterns to Morgan Stanley, from Citigroup to Merrill Lynch, all tapped Asia and the Middle East for cash. Tiny Singapore, with a population of 4.5 million supplied $4.4 billion to Merrill, $6.88 billion to Citigroup and $11.9 billion to UBS. The Chinese supplied $5 billion to Morgan Stanley and $1 billion to Bear Sterns. The Korean Investment Corp. is supplying $2 billion to Merrill just as Mizuho Bank of Japan.

We also argued that “China looks to have the capacity to offset a slow down in the U.S.”. We have not altered our opinion on this either. By looking at the table on this page, the U.S. clearly trumps over any other country in economic size. With a $13.86 trillion economy, the U.S. almost twice as big as China, the nearest in size. Japan represents “only” $4.305 trillion with India’s $2.965 trillion next.

Still, Asian economies represent $18.747 trillion, some twenty percent more than the U.S. This is calculated in purchasing power parity, an important measure to determine how much Asian customers can suck-up in access inventory in case of the U.S. slow down. As the table suggests, Asian combined economies are well in par with the U.S. and just as importantly, they have fiscal muscle left. They not only sit on huge foreign reserves, a staggering $3.166 trillion combined, but are running current account surpluses. Again, they are in excellent shape to weather a U.S. related global economic slowdown.

We have also been arguing that “Chinese companies are expected to report strong corporate profits”. This still holds true. Let’s take a look at current developments. 

Chinese blue chip China Unicom, a major telecom operator in the country, estimates its 2007 net profit more than doubled to at least RMB 7.464 billion from RMB 3.732 billion for the previous year, according to its preliminary estimate filed with the Hong Kong Stock Exchange in January 31.

China Life Insurance (LFC) reported on January 30 that it gained premium revenue of RMB 220.668 billion, or more than 30 percent of the nation’s total.  LFC projected over 50 percent net profit growth for 2007.

Another NYSE listed Chinese blue chip, Sinopec Shanghai Petrochemical (SHI), reported that it expects 2007 net profit to be up more than 50 percent from the 2006 level due to lower crude oil processing costs  and higher investment gains.

And finally, China’s largest financial institution, Industrial and Commercial Bank of China (ICBC), emailed a summary of its just-concluded annual meeting, saying that its net profit grew more than 60 percent in 2007, due in part to a surge in fee income. This was in line with its filing with the Shanghai Stock Exchange, reported earlier in January.

We also said that “the Yuan will continue to appreciate”, an assumption that still holds true. China is still fighting inflation via monetary tightening, resulting in a stronger national currency.

Another point we made was that “excess money from the Mainland will continue to flow to foreign capital markets, primarily to Hong Kong.” We have to alter our position on this condition. We agree with Jing Ulrich, chairman of China Equities at JPMorgan Chase & Co. who said that “global equity volatility is likely to further delay China’s plans to launch financial futures and let individuals invest directly in Hong Kong stocks.” However technical preparations were complete and the market could still get the green light in the second half of the year, she noted. This means that excess liquidity from the Mainland will not pour into Hong Kong and apparently will not give an additional boost to Hong Kong—NYSE cross listed blue chips in the short term.

We also pointed out that we expect the strong IPO activity  in Shanghai to continue in 2008. We have not altered our opinion on this factor. There was one large IPO that can serve as an indication for upcoming IPOs. Shares of China Coal Energy soared in its Shanghai debut on February 1, on strong secondary market demand after its initial public offering was subscribed several times over last month. The company, China's second largest coal producer, raised 25.67 billion yuan ($3.6 billion) last month via an IPO that attracted subscriptions worth $433 billion, according to reports. The stock was recently quoted at 22.95 yuan in Shanghai, compared with an IPO price of 16.83 yuan. Some skeptics pointed out that this is far from previous indications but investors have to remember that Goldman Sacks downgraded the Chinese coal sector on softening coal prices just a day before the IPO. Goldman changed China Coal’s Hong Kong shares from buy to neutral along with China Shenhua and Yanzhou Coal. Nearly 166 million shares exchanged hands on the first trading day. Another indication that a strong IPO activity is likely to continue is China Mobile’s statement earlier in January that the company is seeking a domestic listing as soon as possible. Another blue chip, CNOOC Ltd. (CEO), is also lined up for a Shanghai IPO this year.

Based on all these findings, we think Chinese equities are still presenting sound investment opportunities even though global equity markets  are volatile and make short term investors weary.

And just how volatile January was for China stocks in the U.S., the following two tables reveal some important insights. The following tables lists important changes in the China Xinhua 25 Index (FX), a proxy for U.S. listed Chinese stocks, ranging from “open to close”, “intraday high-low change”, “close to close” and “close to next day open” called GAP.

As the first table suggests, January 23 was the most extreme day in trading than any other day in the previous five months. That day our proxy, FXI, gained a record 8.11% from open to close, swinging 12.09% that day measured from intraday low to high.

Another extreme day was a day from January 17 to 18 when the FXI opened 14.7% higher, a gap that we haven’t seen in the previous five months.

To assess better the difference between the two periods, January 2008 vs. August-December 2007, we created the table on this page. This table looks at the difference in each cell, making comparison readily available. We don’t want to get lost in a mathematical or statistical quagmire but to highlight one important measure at last.

By looking at standard deviation or the last row in each category, OVERALL, UPDAYS and DOWNDAYS, it becomes obvious that updays, e.g. when the market goes up from close to close, were much more volatile than downdays. This important finding we attribute to market nervousness. This implies that if a rally kicks in, it is extremely swift, many times it comes with a huge uptick at the open, diminishing chances for day traders to make profit. It also implies that markets have no confidence when it comes to a rally, since we have seen some extreme rallies in January just to see those gains diminishing the next trading day. With this finding we think that we don’t see much change from January to February. We don’t know where the bottom is or if we have reached it yet. For long term investors this should be no worry though because Chinese stocks present outstanding investment opportunities for the long haul, as we have previously argued.

On the sector level, we continue to like those where demand is likely to remain strong—energy, resources and industrial materials.

With that said, we continue to like Yanzhou Coal (YZC) but with caution. Goldman’s latest downgrade for the sector is something we take seriously and indications that China may intervene temporarily in coal prices to keep power generation at maximum is also a warning sign. Aluminum Corp. of China (ACH) looks attractive on valuation and high alumina prices. China’s NYSE listed independent power generator Huaneng Power (HNP) may get a temporary boost if China freezes  coal prices temporarily. The telecom sector is  still attractive, with CHU as a possible beneficiary of the industry reshuffle. China Mobile (CHL) is seen as a company that gets the short end of the stick in the process. This may push stock prices lower in the short term, however CHL is the best run, cash rich leader in the telecom industry.

On the stock level we continue to focus on companies that offer value by virtue of strong cash flow and margins and those that are leaders in their sectors.

We have been cautious with China Life Insurance (LFC) in the last Newsletter but after the company lost 24. 4% in January, LFC looks good on valuation and market position at the moment.

The same is true to PetroChina (PTR), a company that lost 14.66% in January. PTR is the best positioned Chinese oil major and looks attractive on valuation at present.

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