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May 2009 Newsletter: High Risk, High Return

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April proved to be a good month for investors around the globe. Bulls grabbed the horns of the market steering the DJIA up over seven percent for the month of April. Investor optimism got some chills from China where the Shanghai Composite already rallied forty percent from January till April 21st. Many feared recovery in China was overdone. Those with lower risk tolerance pointed out that earnings are yet to follow improved macro economic indicators such as increase in manufacturing activity or improved bank lending. As a result, the Shanghai Composite contracted ten percent in just seven trading session, from April 21-28.

But when industry leader companies such as ICBC, Sinopec, and China Shenhua started to announce stronger than expected earnings, the indices reversed course and ended the month on a high tone.

From this respect April was a high risk high return month, rewarding the risk taker with handsome returns.



Even better for American investors Hong Kong listed China shares, ones that correlate very closely with American listed ADRs, rallied 12.9% in April extending previous gains since February. This set a high tone for American Depository Receipts or ADRs for April as well.

Even though we fully understand the importance of the American economy when it comes to the performance of global and Chinese equities alike, it’s worth taking a closer look at China for two reasons.

For one, Chinese capital markets have started to depend less on the U.S. as they did before, as we had just highlighted this phenomena in the previous Newsletter on page 2. Following the stimulus package assembled in China, signs point to a direction that the third largest economy of the world is on the way to achieve the proposed eight percent growth for 2009. Goldman Sachs raised its target for Chinese indices both in the mainland and in Hong Kong. According to a recent article on Bloomberg by strategist led by Hong Kong-based Timothy Moe: “China’s aggressive domestic policy stimulus appears to be working to offset the weakness in the external sector”. “Greater confidence in Chinese growth also makes us incrementally more positive about the effectiveness of regional stimuli, and growth prospects.” Goldman’s comments came after UBS AGand other investment banks turned positive on China. The emergence of China as an increasingly independent major powerhouse is also evidenced by a lengthy article in the Wall Street Journal on April 30, “China's stimulus spurs U.S. business” in section B1. This article argues that thanks to China’s 4 trillion yuan ($586 billion) stimulus, U.S. businesses such as Caterpillar find opportunities. This article formulated the fact that China is not simply a major exporter but an increasingly important market for the U.S. and the rest of the world.

The other reason I want you to take a closer look at China is that with lesser dependence on America comes with increased importance of local economic news. With earnings season on, there are plenty to choose from.

As I stated before, corporate earnings are strong. Based on the latest information available, first-quarter profits reported by 1,000 listed companies so far in China totaled 66.6 billion yuan ($9.8 billion), compared with a cumulative loss of 6.1 billion yuan ($892 million) for the final quarter of 2008. And just as important, industry leaders took the helm of the drive as the following list of selective companies testify.

Industrial and Commercial Bank of China (ICBC), the largest financial institution of the world by market cap, reported a net profit increase of 6% despite a 12.9% fall in interest income. Net income grew to 35.1 billion yuan ($5.1 billion) for the first three months. This is not only remarkable given the market environment but it was an important boost for the stock to withstand heavy institutional selling. Western financial institutions were eager to cash out following the end of the lock up period after ICBC’s IPO. Allianz, Goldman Sachs and American Express all sold a significant portion of their holdings to help support their own balance sheets.

China Shenhua Energy, the largest coal miner in China,   reported a 17.2 percent rise in first-quarter earnings thanks to increased coal output.

Sinopec Corp. (SNP), Asia’s largest refiner by volume,  reported a net profit increase of 85.1 percent in the first quarter, fuelled by lower global crude prices. Besides strong earnings, the company sweetened its outlook for the first half of 2009 by predicting net income growth of over 50 percent versus last year. (BIDU), doubted by many simply as China’s Google, reported strong net growth on record sales and just as importantly, an increased market share from 59.3 to 62.2 percent.

Besides corporate earnings, China’s stimulus package is on track of stimulating the economy. It is well evidenced in the pick up of manufacturing activity, loan growth and other key measures. When it comes to loan growth in China, April was another robust month with no signs of easing. According to official statistics, during the first quarter of 2009 new credit reached 4.58 trillion yuan ($671 billion), or 92 percent of a minimum full-year loan growth target set by Beijing. There is an abundant supply of cash in the financial system, a sharp contrast to western banks.

Skeptics are quick to point out that the surge in loans will result in bad loans for state owned banks, a phenomena that cost China over $750 billion in the 1990 to correct.

It’s too early to tell if the sour loan ratio will reach dangerous levels but one thing is for sure: China not only has the vision but also the means to implement a strong stimulus package.

Optimists find comfort in China’s latest GDP data as well.  GDP in China grew by 6.1% in the first quarter, a relatively small number but in quarter over quarter terms it is a significant jump from 2008 Q4, raising hopes that a quick recovery is on its way.

Another important figure is industrial production.  Based on the latest information from the Bureau of Statistics, industrial activity rebounded to 8.3 percent annual growth in March after plunging to a record low of 3.8 percent in the first two months of 2009.

Another important piece of the puzzle is the property market. Investment in the sector has started to recover evidenced by stable house prices combined with an increase in transaction volumes. A large portion of the stimulus package is allocated for public housing, further increasing demand for construction materials.

Still, I expect a bumpy road ahead for China stock investors for the short term.

For one, the Shanghai Composite is up 36.1% YTD and up 45.2% since November 4, 2008. Such a stellar performance makes investors leery.

Another concern is that while profits are up sharply from 2008 Q4, they still lag way behind year ago levels. Based on the latest statistics, profits of Chinese industrial firms' are down almost forty percent in the first two months of 2009 vs. same period last year.

Another possible sour spot is overcapacity. With so much capacity idled, from aluminum smelters to iron producers, signs of price recovery in the metal sector resulted in ramped up production volumes. This in turn produced only a glut of the metal, evidenced most in the iron sector, as demand is still behind production volumes, shattering profitability of metal companies.

Exports have fallen for five straight months and though its pace is slowing, millions of jobs have been shed in the process.

As I pointed out, pick up in China’s economic activity is based on public spending while the private sector has been sluggish in response. Public spending carries more risk for banks for bad assets, a potential sour spot likely to surface in three years or more, thanks to Chinese accounting standards. It will take some time to fully understand the impact of the stimulus package on the banking system, hiding risks for the short term.

So how to play China for the upcoming few months?

As I have pointed out frequently, Morgan Stanley China Fund (CAF) is the best way to ride on the back of the strength in Shanghai. This ETF is very well constructed to follow the Shanghai Composite and has been making a lot of money for those who jumped on the wagon since November 2008. Again, the index is up almost 40% YTD and as such carries some risks. But as the title says, high risk rewards you with high return.




Another way to play China is finding the right stocks. Please take a close look at both our Conservative and Growth portfolios, they just did superb for April following a strong performance in March. Both are up over 20% for the months, on average. Going stock specific, Sinopec Shanghai Petrochemical is up 38.1% for the month and I think it is a good time to take some profits off the table. The rest of the Conservative portfolio is good as is.


Looking at the Growth portfolio, all stocks are up double digits for April except for China Mobile (CHL). The reason I’m not taking it out for May is that China Mobile is an index heavy weight and a good defensive play. With its loyal customer base and most reliable cellular network in China, CHL comes in handy when market sentiment sours.

The rest of the portfolio performed beyond expectations. Shanda Interactive (SNDA) hit all time high of over $53 on April 16 and has been trading above the $50 level numerous times. I personally think is a good time to take some profits off the table when it comes to Shanda.

Another stock I recommend to short is City Telecom (CTEL). This small cap carrier was added to the growth portfolio in last November and is up over 65% since inception.

Despite a staggering 31.9% gain in April, (BIDU) looks good to me. The stock is not overbought, is fundamentally very solid and is far from its all time high of over $409. But you have to have a strong stomach with this company because it is very volatile and sensitive to market sentiment. But again, fundamentals eventually take over and this is when BIDU shows its worth.

And if you’re willing to take on more risk, I have some surprise stocks for you. In my quest to tap directly into stocks that benefit the most from the stimulus package. I ventured into unchartered territory: the pink sheets. Pink is a broad term and make many investors weary, and for a good reason. However some companies are listed in this loosely regulated market not because they have something to hide but rather for reasons of convenience after the Sarbanes-Oxley.



Angang Steel is a direct beneficiary of the construction boom. Despite a 95% net profit drop in the first quarter, this large cap steel maker is expected to recover with the commodity boom. Jiangxi Copper, China’s largest precious metal miner and smelter, is very similar in nature to Angang Steel. And finally, Tsingtao Beer, the largest beer producer in China, is well positioned to take advantage of increasing disposable income among ordinary Chinese citizenry.

Wish you profitable investing, Blaze Fabry




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