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April 2009 Newsletter: DJIA recovers. What does it mean for China stocks?

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What a difference one month makes! Headline for the previous issue said “DJIA goes bust. What does it mean for China stocks?” A month later the headline changes to DJIA recovers.

Looking at the latest figures  the DJIA gained 7.7% for the month, making March 2009 the best month since October 2002. But China stock investors had a good reason to cheer globally. While the Hang Seng Index advanced 6.0% for the month and the China ADR Index a modest 4.9%, the Shanghai Composite soared 13.9% in March and is up 30.3% YTD.

We at Chinavestor had no idea that March would be such a stellar month.  We  have repeatedly pointed out in previous issues that the resurgence in Shanghai is driven by fundamentals and as such is less likely to turn around. But the magnitude of the stellar performance in March was a pleasant surprise. We exercised caution in the previous Newsletter saying that “it’s difficult to suggest a buy when all major indices head south” on page 3.


And just how strong Shanghai has been is best illustrated by the fact that the first quarter of 2009 is the best start for the index since 2000 and is the best performer so far this year among 90 global indices.


There are three major factors contributing to this  exuberance:

1. China introduced a 4 trillion Yuan stimulus package

2. Banks continued record lending

3. There have been five interest rate cuts since last November.

There is plenty of liquidity in China as a result of these macro economic measures. China Securities Regulatory Commission is riding on the back of excess liquidity and announced that it will begin looking into IPOS beginning next month.

The majority of investors bet that China will be one of the first countries to recover and if so, stocks are undervalued. Some skeptics are pointing out that the recovery is ‘overdone’ and is not supported by earnings. It’s impossible to tell who is right but we are of a view that Chinese stocks will continue to outperform as long as global markets remain at least neutral. And signs point to a direction of modest recovery for the rest of the year, a sign that suggests investing in Chinese equities isn’t late yet.



History tells us that Chinese stocks outperform during global economic expansion, a fact that is not likely to change in the next few years. There has been only two periods since 2000 when Chinese equities did not follow American market sentiment.

To illustrate this, take a look at the two charts on the right. The first one displays the performance of the DJIA, the Shanghai Composite Index and the Hang Seng Index from January 2000. The second chart displays the same indices but on a logarithmic scale for a better resolution. Also, we started the charts from a 50% starting point, so negative performance of the indices would not render the logarithmic scale useless.


While the first chart is something most eyes are accustomed to, we like to pay attention to the second chart as this one is much better at looking into details.

The first period when the Shanghai Composite and the DJIA went in opposite direction started in March 2003 and lasted until November 2005. During this period of time the DJIA advanced over 2,100 points while the Shanghai Composite hit an all time low. But this was due to an oversupply of shares while mega IPOs flooded the market. Excess supply was met with not enough liquidity to absorb it and kept Chinese equities at bay.

The second period was much shorter and started in November 2008 until February 2009 during which time the DJIA lost 1,750 points while the Shanghai Composite advanced 350 points or 20 percent.

One of the lessons from this chart is that unless some special circumstances occur, Chinese equities follow American market sentiment. And this remains key in determining what to expect from China stocks listed in the US and in China for the rest of the year and beyond.

If American stocks markets recover we expect Chinese stocks to do well. Based on the latest developments we are hopeful that the worst is  over but some say that the market is just looking for direction from here on. To play it safe we will give you stocks for both scenarios. One set of stocks should the bull market continue and one set of stocks that are defensive in nature and might come in handy if the bears gain the upper hand. Some say that the market is looking for direction from here but I’m of the opinion that the market will at least level off or rather continue to recover. But one thing is certain: market extremes are here to stay.

Think about this: during the first quarter of the year we have experienced a bear market and a bull market, something we had to wait for years to develop. And just how extreme this quarter was consider this: we have seen the fastest and the shortest bull market since 1938. WSJ reports on Friday March 27 that according to my former employer, Birinyi Associates, “The advance required a mere 13 trading days from March 9’s 12-year low, making it the fastest 20% rebound  from a bear market low since 1938”.


So if this bull market was the fastest it certainly was the shortest as well, because as soon as the DJIA improved over 20%, it fell 402 points in the following two sessions. But again, bulls grabbed the horns of the market at the last trading session ending a volatile period of time.



Besides market sentiment, earnings reports have come out from Chinese blue chips, giving directions for the rest of the sector. We have issued a telecom specific study at the end of last year, distributed to all subscribers, about the change that 3G licenses will bring to the sector. In that study we argued that China Telecom (CHA) is a winner and long time favorite China Mobile (CHL) will face increased competition from CHA. We also pointed out that China Unicom (CHU) is a possible loser of the industry restructuring and as such we suggested shorting this stock. China Unicom not only underperformed both peers but announced 2008 results that left the company in a vulnerable position. While profits came out strong, thanks to a one time sale of its CDMA network to China Telecom, outlook remained dim and investors sold heavily the company that fell 4.4% for the day. On the same time shares of China Telecom soared 3.6% at the same time.

Aluminum Corp. of China (ACH) reported 2008 numbers that were worse than expected. Profits all but evaporated and the company warned of a bleak fist quarter for 2009. However this didn’t change our long term view of the company because all this news was already incorporated on its price. Aluminum companies are under the weather globally, Alcoa (AA) just became a target for Rio Tinto (RIO) according to the latest market reports. In essence we think Aluminum Corp. of China (ACH) remains an attractive company, especially if commodity prices continue to recover.

We made a strong case for Sinopec (SNP) in a previous Newsletter and we feel justified after the 2008 Annual Reports of all three major Chinese oil companies. While SNP reported in line with expectations, the outlook sweetened on oil prices and higher refining margins. As a result, the stock has started to break away from it peers, CNOOC ltd. (CEO) and Petrochina (PTR).

Looking at the market as a whole, there is one concern that bears like to point out when it comes to Chinese stocks. They argue that there is a significant valuation gap between Shanghai and Hong Kong listed shares. Shares traded in Shanghai are 77% more expensive there than in Hong Kong and the valuation gap is increasing, as the chart on this page shows. The last time the difference in multiples was this wide, the Chinese shares lost 19 percent in 30 days. But bulls like to see the cup half full. They argue that if China let mainland investors invest directly in Hong Kong, via a revitalized “through train program”, share prices in Hong Kong will explode and catch up with Shanghai.


Either way, we give you stocks for both bull and bear markets, just as we promised on the second page.

A common measure of risk is “Beta” or a stock’s tendency to follow the broader stock market. The higher the Beta the more volatile the stock. When a stock’s Beta is exactly 1.0, it means that a stock moves right along with the market. If beta is less than 1, a stock is considered defensive because it has less volatility and fluctuation than the overall market.

Another common measure we like to use is price to earnings ratio or P/E. But under current circumstances when companies earnings are shattered, at least temporarily, P/E ratios are just wild. So we just stuck to Beta this time.

The top of the table on the right lists the most defensive China plays as of today. Interestingly NASDAQ listed China stocks top the list: Shanda Interactive (SNDA) leading. Asia Info (ASIA), NetEase (NTES), China Tech Faith (CNTF) and Kong Zhong (KONG) are the most defensive plays out there.

HSBC Plc (HBC), Huaneng Power (HNP), and China Mobile (CHL) are the largest cap stocks that have very low Beta.

When it comes to risky stocks, or stocks that tend to jump big when bulls have the upper hand, I like Yanzhou Coal (YZC), China Telecom (CHA) and airliners, China Eastern air (CEA) and China Southern Air (ZNH).

Suntech Power (STP) and the whole solar industry as a matter of fact, is extremely risky. Prices of solar companies jumped 60% on average on March 26 following news that the Chinese government will give significant subsidies for the industry. But news is not earnings yet and I expect extreme volatility to remain in the sector.

And finally, I want you to take a very close look at the Conservative and Growth portfolios at the end of the Newsletter. There has been no major change from last month and we’ll make no changes in this month either because both portfolios performed extremely well so far this year. Please consider picking names from the portfolios or give me a call so I can discuss it further with you.

Wish you profitable investing, Blaze Fabry
























































































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