We took the risk to say a month ago that “we think Chinese equities are nearing the bottom. Looking at Asia and China in particular, we find both macro and micro economic data to fuel our optimism. “

Since then the China ADR Index (CAI) rallied 7.5% in line with the Hang Seng’s 7.0% comeback, outshining the Shanghai Composite’s modest 3.7%  rally. Have Chinese equities bottomed out?

Finding direction from the U.S. economy is difficult. The FED decided on April 30 to cut interest rates by a quarter point, but failed to give a firm indication about its future moves. Warren Buffet came out lately  warning that the economy may be in worst shape than may thought; but consumer spending was rising in March and strong earnings in the tech sector suggest developments contrary to Mr. Buffet’s wisdom.

As a result we think investors in Chinese equities will have to live with sizeable ups and downs with a tendency of lowering magnitude in the upcoming months.

For the next six months we are optimistic based on strong first-quarter earnings, revised earnings prospects for the rest of the year and positive macroeconomic indicators in China.

Recent regulatory changes have contributed to a resurgence of Chinese stocks, changes that are likely to affect longer-term prospects as well.

Moving to stabilize the markets, the Chinese Securities Regulatory Commission announced on April 19 that shareholders who want to sell large numbers of shares news freed from lock up periods must do so through the “block trading system”. That requires such sales to be made through private negotiations between buyers and sellers of the large chunks of shares. It “is set to counter selling pressure on the public market and help relieve investors’ worries over the impact of share disposals,” the CSRC said in the statement. Secondly, China cut its stamp tax rate, the tax it charges on the purchase or sale of stocks, from 0.3% to 0.1% on April 24. Officials also said institutional investors buying or selling over 100,000 shares have to do it privately. This news sent the Shanghai Composite Index soaring 9.3%, the biggest single-day gain in seven years.

Despite recent gains, Chinese equities look very attractive from a valuation point of view. As the following chart suggests, the China ADR Index (CAI) is down by –10.0% year-to-date (YTD) at 900.29 points while the weighted average P/E is down from 42.73 to 25.30, a drop of 41.0%.

The significant difference between the drop in the index value and the P/E may be explained by the fact that the strong earnings are not yet reflected in stock prices. The chart reveals that after March 3, when earnings started to come out, the average P/E ratio dropped significantly from 30.64 to 15.80 within three weeks yet the index value remained virtually unchanged.

As an example take a look at market reaction to the earnings announcement of China Mobile (CHL) on March 19. China Mobile profit jumped 37% with no signs of slowing down. The stock advanced a modest 3.2% following the earnings announcement, a subdued reaction to a spectacular performance. “The rapid growth in China’s economy and the vigorous demand for telecom services continued to create a prosperous environment for the Group”, said CHL in a statement.

As markets gained some confidence  CHL added an additional 20% gain thus eroding some of the discrepancy between stock price versus valuation but is still trading at a modest valuation.

Looking at recent earnings announcements, Chinese equities came out very strong with exception of the oil industry.

The banking sector, a barometer for the health of the overall economy, performed spectacularly. Three factors have also added to the profitability of the sector. The income tax cut from 33% to 25% was one; the lower than expected subprime write-downs  was two; and higher interest on consumer lending, a flexibility Chinese banks were granted lately, was three.

As a result ICBC, the world’s larges bank by market capitalization, posted a 77% jump in first-quarter profit on April 22, boosted by lower tax charges and strong growth in interest income and fees. Bank of China, the second largest Chinese financial institution, posted an 85% jump in first-quarter profit. Bank of communications, a bank HSBC Plc. (HBC) owns a 20% stake, reported a doubling in first-quarter profit.

Besides the financial sector, Yanzhou Coal (YZC) reported a first-quarter profit jump of 112.7% followed by China Eastern Airline’s (CEA) return to profitability the same day. Guangshen Rail (GSH) reported year net profit up 85.5% while China Southern Airlines (ZNH) swung back to profitability in the first quarter on currency exchange gain.

Some of the quality NASDAQ names reported stunning results. Baidu.com (BIDU), China’s premier search engine and a company that’s been with our Growth portfolio for over 6 months, reported better-than-expected quarterly profits thanks to strong traffic growth and strong online advertising before the Beijing Olympics.

Sohu.com (SOHU), one of China’s leading web portals  posted a nearly fivefold surge in quarterly profits with strong guidance for the rest of the year.

Another industry leader, Shanda Interactive (SNDA), from the online gaming industry, reported 52% revenue growth on customer increase.

NetEase (NTES), China’s second largest online game operator by revenue reported a 22 percent rise in quarterly profits on traffic increase and tax gains.

Crip.com (CTRP), China’s largest online travel agency reported over 100% profit growth.

Strong earnings from NASDAQ companies prompted spectacular gains that raised analysts’ eyebrows. SOHU was downgraded by Oppenheimer on May 1st citing valuation concerns after recent rally of over 80% since March 20.

We are on the view that companies operating independently from the government  are poised to do well. The problem is when the government steps in. Take a look at China’s largest independent energy supplier, Huaneng Power (HNP). The company generated 18.6 percent more electricity yet its first-quarter profits fell more than 50%. The problem is that Beijing regulates electricity prices while gave up control of coal prices. Since coal accounts for over 70% of electricity production, rising coal prices have been squeezing profits out of electricity providers.

This type of problem is not limited to one industry. Oil majors posted disappointing earnings as Beijing wants to tame inflation despite record crude prices. As the charts suggest China’s GDP maintained a healthy growth of over 10% during the first-quarter while inflation seems to be at check for the moment. So from macroeconomic point of view China is on the right track however some listed companies suffer.

China’s larges oil producer, Petrochina (PTR) posted a disappointing 32% fall in net profit for the first-quarter. Sinopec (SNP), Asia’s largest refiner, suffered a 69% dive in first-quarter profit. The good news is that these companies will start receiving government subsidies every month against losses due to processing imported crude. CNOOC Ltd (CEO), China’s off-shore oil producer said it produced 5% more oil & gas in the first-quarter while its total revenue jumped 61.8%. Yet it doesn’t translate to profit growth because of the windfall tax   of 40% on the portion of the price of a barrel of oil above $60. Under current regulatory conditions we don’t recommend taking positions in any of these oil companies.

Another disappointment was China Life (LFC), China’s largest life insurer. The company reported a 61% fall in Q1 earnings hit by poor investment performance. This should come as no surprise just by looking at the performance of the Shanghai Composite, the index that lost over 50% its value since peaking last October. The good news is that earnings for China Life will get a boosts from a steadier stocks market. The main index has rebounded from a 13 month low and is expected to perform well in the upcoming months.

Another important development for LFC is that Beijing moves to allow insurance firms to invest directly in the properties market. This could potentially unleash billions of dollars and give insurers a steady income they need to  balance long-term liabilities. This should certainly benefit LFC along with a steadier stock market. We think China Life looks attractive at current prices.

Looking at the near term perspective for the Shanghai Stock Exchange, consider two additional developments. China is amending its rules governing investment by Qualified Foreign Institutional Investors (QFII) and will relax the time limits for QFIIs to move funds across the Chinese border. This is aimed at encouraging foreign institutions to make medium– and long-term investments in China’s capital markets.

Not that China needs additional capital that much. As the following chart suggests China’s foreign exchange (FX) reserves totaled $1.68 trillion at the end of March 2008, jumping $154 billion in the first-quarter.

Again, developments in China are very encouraging. Inflation started to slow while GDP growth remained robust. The country sits on a huge FX reserve to promote economical activity if it needs to. On a regulatory level Beijing took steps to promote the Shanghai Stock Exchange and quality companies not affiliated with the government are poised to do well.

At this time we like China Life Insurance (LFC), China Mobile (CHL)  and Yanzhou Coal (YZC) from the NYSE listings. Among the NASDAQ listed China names, we keep a positive outlook of Baidu.com (BIDU), Ctrip.com (CTRP), NetEase (NTES) and Shanda Interactive (SNDA).

We wish you successful investing.

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