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February 2009 Newsletter: Opportunities ALWAYS exist

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It is hard to be optimistic when indices all over the world continue to deteriorate. One exception is China where the Shanghai Composite eked out a 3.2% gain in January. As we pointed out in previous issues, the Morgan Stanley China Fund (CAF) is one ETF that tracks the performance of the Shanghai Composite relatively closely. If you happen to be invested in that, you have some reason to cheer. The reason for a relatively good performance of the index lies in the increased confidence that China’s own stimulus plan, Yuan 4 trillion in size or 16% of the GDP, will help lift China out of the global downturn and keep its economy growing at 8 percent in 2009.  Sentiment in China visibly improved when government figures surfaced that lending in China was up in December, a key measure of economic activity.

But China still faces tremendous challenges ahead such as rising unemployment, shrinking external demand and overcapacity in some sectors. In all, it’s too early to tell if China is already on a sustainable path to recovery but the markets have shown some confidence.

Most western investors had to live with a dwindling American market or worse, Chinese ADRs. As the following chart on the page displays, the DJIA lost 3.1% in January but the China ADR Index (CAI) performed even worse, giving up 7.8% for the month. This is in par with stock performance in Hong Kong, the true international market for Chinese companies. The Hang Seng Index lost 7.7% in January as investors abandoned financial stocks amid stake reductions by strategic investors and dumped HSBC altogether.



With no direct exposure to financial stocks in New York—no major Chinese banks are listed here - large cap blue chips such as Petrochina (PTR), China Mobile (CHL), Sinopec (SNP) weighted down the index. Smaller players such as Aluminum Corp. of China or Chalco (ACH) or China Unicom (CHU)  were hurt even more. And with lowered 2008 earnings guidance from firms such as Yanzhou Coal, Sinopec and Chalco, a somber tone is set for the current earnings season.

 The world economic forum in Davos, Switzerland, is another good barometer to get an idea where the world is heading in 2009. While  the opening keynote speeches centered around the economic crisis facing the world, the speech of China’s premier, Wen Jiabao, indicated that China is aiming to keep its economic growth at 8 percent. Looking at GDP for the whole world, it is predicted to contract in 2009 for the first time since 1945. It is hard to tell when the United States will recover but one thing is for sure: weakness in America plagues the rest of the world. What is certain is that things will just get worse before they get better.

Actually January is one of the worst months to gauge the overall economic picture. With fourth quarter earnings coming out we get an idea how bad the last quarter of 2008 was. This is when the crisis spread resulting in massive lay offs and a meltdown in the financial sector. From that respect we are seeing the worst of it all. And while it’s unrealistic to tell if the stimulus packages will work, a 2008 Q4 measure reflects the drastic change from quarter to quarter, not necessarily the best indication for the future.

Regardless of the economic situation, we are here to help you by identifying trends, stocks or sectors that we think present opportunities. Because opportunities ALWAYS exist.

This particular issue is unique in a sense that we will not concentrate on earnings despite being in the middle of earnings season. The reason is that world economic news is dominant in determining Chinese ADR prices while earnings became secondary, at least for the short time.

Take a look at Aluminum Corp. of China (ACH) for instance. This is a stock that we highlighted back last fall saying that it presents an outstanding opportunity under $10. When China’s stimulus package got unveiled with massive infrastructure and construction spending included, we knew aluminum will be in demand.  The stock got another boost from government steps that were aimed at helping the commodity and metal sector via a massive build up of aluminum, zinc, copper, among other. Altogether ACH traded above $16 for some time and unless you are in for the long haul, you could make an easy 50% profit. During economic times like these, it seems just too good to be true. But it was. And again, it wasn’t earnings announcements or a stock specific news that moved the stock more than 50% but it was an oversold value stock waiting to be discovered. And now that economic gloom hangs over markets again, Chalco is back to $11.20 as we speak.


Then we studied the telecom sector before the 3G roll out to identify what companies will be winners. We issued a comprehensive telecom sector overview  over a month ago focusing on challenges and opportunities 3G licenses meant for China’s telecom triumvirate. We argued that while China Mobile (CHL), long time favorite of the sector, will face challenges but do well, China Telecom (CHA) will benefit the most from the industry overhaul while China Unicom (CHU) is the likely underdog. The widening gap between CHU and the rest of the sector testifies how good our analysis was and that opportunities still exist despite a hostile stock market environment.

So looking into the future there is another potential stock we like now and this is Sinopec (SNP), Asia’s largest refiner.

We heard many arguments that the Chinese oil companies are hurt on two fronts these days: one for lower crude price and two for dwindling oil demand. And there is a lot of data out there to support both claims.


The first chart on the page displays how China’s thirst for oil slowed down and growth eventually evaporated by November due to the economic melt down. We also are aware that the crude price per barrel dropped from its peak of $145 to somewhere around $40 by the end of January, a drop of over 70%. Combining evaporating demand with weak prices, oil companies around the globe are facing tough times ahead.


The second chart displays Chinese oil refinery runs, providing evidence that in the last month of 2008 Chinese refineries actually cut back in production. This move is in line with lower oil demand as the first chart depicted.


So the case is strong for a severe punishment of Chinese oil companies. As the third chart on the page displays, market reaction was swift and decisive: all Chinese oil majors have suffered heavy blows. The punishment is universal, Sinopec is somewhat weaker than Petrochina (PTR) or CNOOC Ltd (CEO) but the difference among the three is minimal.

But this makes a case for Sinopec in our opinion. Markets are putting SNP on the same page as PTR or CEO yet they are fundamentally different.


While CNOOC Ltd (CEO) is a pure oil producer Sinopec is the largest oil refiner in Asia with some oil production of its own. Petrochina is Asia’s largest oil producer and has substantial refining capacity as well. So while CNOOC Ltd is suffering as a result of lower crude price while its oil exploration grew by 3.6% in the last six months, Sinopec is making money when the crude price goes down. Gas price for end users, e.g. cars, trucks and industrial users, is set by the state. And while we have seen more flexibility from the government in the last two months to follow international gas prices closer, there was only one price cut since last July when crude prices peaked at $145.

The problem for Chinese refiners was that while they paid international price for the crude they were unable to pass over higher cost to consumers due to government price caps on gas. But since crude prices have collapsed, Sinopec has a strong case.

Our analysis is based on the following presumption: Sinopec makes money when crude price is below $54. As the bottom chart on the page displays Sinopec has returned to profitability since early October and is making lot of money ever since. So while 2008 results will be horrible and yet to be reported, smart investors should take a position in Sinopec now and look for 2009 first and second quarter numbers to be reported. We expect Sinopec to report extraordinary numbers then especially compared to oil producers like CNOOC Ltd or Petrochina. If you have positions in Petrochina or CNOOC Ltd we think you may want to rotate because Sinopec is the best choice among Chinese oil majors at this point.

And just how much energy  prices and government action have driven stock prices lately take a look at China’s largest independent power generator, Huaneng Power (HNP). 

The company reported mid January that it expects a loss for 2008 on high coal prices while power prices were kept low due to government regulations. But rumors that Chinese authorities will announce massive spending in energy as part of the stimulus package sent Hong Kong listed H-shares of Huaneng soaring on the last trading day of the month. This strong momentum carried over to New York carrying Huaneng ADRs with the same ferocity. It is early to tell if those rumors will come true or will have a lasting effect. But the fact that a government stimulus related rumor can propel a large stock over 10%, is highly unusual.

Another energy related sector is airliners. The simple biggest cost item for any airliner is the price of jet fuel. When crude hit $145 a barrel airliners were screaming—except for those that had hedged fuel prices prior. But altogether high fuel prices mean loss of profit for airliners. With oil coming back to the $40 level, it may be time to rethink airliners. We are aware that air traffic is down in China based on interim reports from Air China, Cathay Pacific and China Southern Airlines (ZNH). But considering that passenger volume dropped a mere 3.4% on average while kerosene prices fell over 10 times as much, Chinese airliners are worth to look at. Additionally, overcapacity won’t be a problem for 2009 since both China Eastern Airlines (CEA) and China Southern Airlines (ZNH) opted out of new jet deliveries for the year and have trimmed fleet size accordingly. And finally, Chinese airliners lost 80% of their stock value in the last year making it one of the worst hit sectors. With significant improvement on the fundamentals, we think it is time to build some position in airliners.


In the previous Newsletter we argued that NASDAQ listed Chinese ADRs improved significantly on valuation compared to their NYSE listed counterparts. This would suggest that we spend a significant part of this issue identifying stocks from that exchange. However the global financial meltdown has significantly increased risk of investing in smaller cap Chinese stocks, most of which are listed on the NASDAQ. But there are two stocks that we like at this point: Shanda Interactive (SNDA), China’s largest online game developer and operator, has shown signs of strength despite a weak market environment. Given that Shanda is the industry leader with an exceptionally strong game pipeline, you may want to think about this blue chip.

The other one that caught our eye is another game operator, The9 Limited (NCTY). Based on preliminary numbers these two players are poised well to withstand weakness in the sector, a sector that represents the largest revenue and profit segment of the Internet in China.

Wish you successful investing,

 Blaze Fabry

Chinese carriers Feb ‘08—Jan ‘09


Crude price vs. break even point last 12 months


Chinese oil sector Aug ‘08—Jan ‘09


Chinese telecom sector Dec ‘08—Jan ‘09


Major indices in 2008-2009


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