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How to play China stocks in June 2011

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questionmark June 2011 (Chinavestor)  “That’s my story and I’m sticking to it” - when it comes to inflation in Asia and China in particular. We have noted in several Newsletters this year that inflation is playing a central theme in the performance of equity markets in China. There is no reason to alter our opinion going forward. While Chinese stocks are looking very good from a corporate point of view, fear of additional monetary tightening continue to keep them at bay. Actually, the Shanghai Composite Index (SHA:000001) is trading near the lows for the year, making it one of the worst performing major indices world wide for the year. Another telling statistic is that the index is off by 11.5% since the middle of April, in sharp contrast to the Dow Jones Industrial Average (INDEXDJX:.DJI) for the same period. As far as the Dow is concerned, despite a steady decline in May the index is still in the black for the year. The weakness for the DJIA in May is due to two factors. One, the index enjoyed a robust four month advance earlier this year, making it susceptible to a correction. And two, market participants are waiting for more clues that the recovery in the world largest economy is genuine. The good news is that corporate earnings have been relatively strong, giving U.S. stocks a sound footing.

Stocks mentioned in this report include Sinopec Shanghai Petrochemical (NYSE:SHI), Huaneng Power (NYSE:HNP) Silvercorp Metals (NYSE:SVM). Two key ETFs of the Newsletter are iShares FTSE/Xinhua 25 China Index (NYSE:FXI) and Morgan Stanley China A Share Fund (NYSE:CAF). NYSE listed Chinese IPOs lately  from SouFun Holding (NYSE:SFUN), Youku.com (NYSE:YOKU), Qihoo 360 Technology (NYSE:QIHU) and RenRen Inc. (NYSE:RENN).

The Hang Seng Index (INDSEXHANGSENG:.HSI) fared relatively better than most indices in May but it doesn't have much to show for the year.

Market cap weighted China ADR Index, measuring the performance of Chinese stocks listed in the U.S., was outperforming the rest for May thanks to Petrochina Co. Ltd. (NYSE:PTR), the largest Chinese oil producer.

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The good news is that the fundamental reason behind the weakness of Chinese stocks can change. Inflation has already peaked in Indonesia and Singapore, suggesting China may be able to reign over it by the end of the second or the third quarter of this year. When that happens, Chinese stocks are likely to catch up with the rest of the world. The depth of the rally is unknown but the current gap between the Dow Jones Industrial Average (INDEXDJX:.DJI) and the Shanghai Composite Index (SHA:000001), caused by inflation worries since last November, is 23 percent. Should Chinese inflation come under control, a good 25 percent rally is possible.

The rally is the most likely scenario for another reason. Corporate earnings in China are solid, making Chinese stocks attractive on valuation. But investors have to be smart as to what sectors to prefer going forward. To find some clues about this, let’s see what factors are going to drive the market.

One market driver is the Federal Reserve. As the FED will significantly slow down buying U.S. Treasuries after June, the loose monetary policy is coming to an end. This may well help the dollar to bounce back up.

Investors know that a strong dollar hurts commodity and related stocks the most. Metal and energy stocks tend to outperform when the greenback is strong. This implies that oil producers are going to feel a pinch should the price of crude fall. But upstream oil companies, such as refiners and byproduct makers, are going to benefit from lower oil prices. Sinopec Shanghai Petrochemical (NYSE:SHI), the largest ethylene producer in China, may well break the negative trend of the past 4 to 5 months.

Huaneng Power International (NYSE:HNP), the largest independent Chinese power generator, may also benefit from lower coal prices. Another good news for this company is that China will raise retail electricity prices as of June 1st, the first such hike in over a year.

But Petrochina Co. Ltd. (NYSE:PTR), the largest Chinese oil producer, along with CNOOC Ltd. (NYSE:CEO), China’s offshore oil specialist, may fall should oil prices subside.

Silvercorp Metals (NYSE:SVM) is the closest U.S. investors get to Chinese metal stocks. But timing this silver miner is tricky for a number of reasons. When markets fall, investors tend to find safety in precious metals like gold and silver. So should the market fall on a commodity driven decline, precious metal stocks may find support for a different reason.

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But there is at least one way to safely play a possible Chinese rally: buying index tracking ETFs. The Morgan Stanley China A Share Fund (NYSE:CAF), an ETF designed to track the Shanghai Composite Index (SHA:000001), is an obvious choice. As we have just argued before, there is a 23 percent gap currently between the DJIA and the Shanghai Composite Index (SHA:000001). Investors buying Morgan Stanley China A Share Fund (NYSE:CAF) can track the performance, and a possible bounce back, of the Shanghai Composite Index (SHA:000001).

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Another possibility is to track Hong Kong listed Chinese stocks. Considering that the Hang Seng China Enterprise Index is trailing the DJIA by a wide margin, the potential for upside is substantial. The FTSE/Xinhua 25 China Index (NYSE:FXI) is a very close proxy for the Hang Seng China Enterprise Index (INDEXHANGSENG:HSCEI) as the second chart on this page testifies. Considering that this ETF is a financial heavy weight, a sector that’s under represented among U.S. listed Chinese stocks, western investors have a very good tool to track hard to reach Chinese stocks, thanks to the iShares FTSE/Xinhua 25 China Index (NYSE:FXI).

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The good news is that both ETFs have ample volume on the NYSE, making entry and exit into them easy and relatively inexpensive.

The flip side of ETF investing is that they represent, by definition, the low risk/low return category. Investors with more risk appetite have to find “hot” stocks to beat the market.

One of the hottest opportunities has been IPOs, domestic and international alike. LinkedIn Corp. (NYSE:LNKD) created a lot of buzz in the internet / social networking sector, just after the debut of RenRen Inc. (NYSE:RENN), dubbed as the Chinese version of Facebook.

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Qihoo 360 Technology (NASDAQ:QIHU), a Chinese anti virus software developer, had a rocky performance since its IPO earlier the year, just like Youku.com Inc. (NASDAQ:YOKU), another good sized Chinese internet stock. Chinese internet television pioneer Youku.com Inc. has been doing very well up until the middle of May, when first quarter earnings put an end to its spectacular rise.

SouFun Holdings Limited (NYSE:SFUN), a Chinese real estate internet portal, hasn’t been living up to its potential either, making investors wonder about longer term perspectives of the latest Chinese “hot” IPOs.

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We are not here to say that Chinese IPOs are of low quality. LinkedIn Corp. (NYSE:LKDN) is trading almost 10% lower than its IPO price. There is no “easy money” for sure. Just like investors have to remain vigilant with small cap Chinese stocks, a new phenomena we highlighted in our April 2011 Newsletter. Since then we have another Chinese company falling apart: China Green Agriculture (NYSE:CGA). The stock tumbled 30% last week alone. Again, we consider anything trading under a $250 million market cap dangerous where investors have to exercise extra caution.



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