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July 2009 Newsletter: Strong rally in first half puts valuation in focus

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questionmarkShanghai listed Chinese stocks continued to rally in June while indices in Hong Kong and the U.S. went sideways for the month. The Shanghai Composite advanced another 12.4% in June making it to a staggering 62.5% performance YTD. Strong international and domestic money flows have propelled Shanghai listings since November 2008 and the question is this: how long will the rally last?


Major indices in 2009


Looking at the largest Asian market, Japan, signs are encouraging. The Nikkei 225 rose 12% in the second quarter of 2009, the best quarterly performance since 1995. India’s index, another proxy for Shanghai, is up 50% YTD, with most of its gains after the decisive election victory of the ruling party. Anyway we slice it, Asia is hot.

Trading in the U.S. still doesn’t give much reason to cheer, the DJIA is back in the red for YTD. American lack of momentum kept U.S. listed Chinese stocks at bay for the month of June but the China ADR Index compiled by Chinavestor is up 10.4% YTD. Trading in Hong Kong is affected by American market sentiment and Chinese domestic news and as a result, the Hang Seng Index is in the middle of the Shanghai Composite and the DJIA. But with a gap increasing between American and Hong Kong listed Chinese stocks, the price gap between Shanghai and Hong Kong has started to close. This is evidenced by the fall of the Hang Seng China AH Premium Index in the last two months, an index that measures the difference between Shanghai and Hong Kong listed shares. The reason investors have to pay attention to such price differences is that by doing so global investors can track money flows and predict future trends.

Hang Seng China AH Premium Index


Based on the following observations, e.g. differences between Shanghai, Hong Kong and New York, it is evident that strong money flows in China are responsible for the stellar performance of the Shanghai Composite and with no signs of monetary tightening, we expect the Shanghai Composite to continue to rally for July. Based on the narrowing gap between HK and Shanghai listed shares, there is no China bubble building yet. This should give investors confidence investing in Chinese stocks both in Hong Kong and in New York.

Even though there is no bubble building, valuation comes into play after such a stellar performance. At Chinavestor we are fully aware of the different stock characteristics of NYSE and NASDAQ listed Chinese stocks. The NYSE boasts the largest Chinese state enterprises while the NASDAQ was successful in attracting smaller cap, entrepreneurial companies. As a result, their trading is very different in nature. For this reason we will study valuation for the two stock groups separately.

As the following chart displays, price changes of NYSE listed stocks are accompanied by earnings growth, thus the yellow and orange lines are in tandem. This we interpret as no Chinese stock bubble has been building on the NYSE. A bubble is building when P/E is rising much faster than actual stock price, e.g. valuations become excessive.



The second chart depicts stock performance of the NASDAQ China stock universe. While the price chart suggests that stocks have rallied 50% on average since January 2009, P/E ratio has remained the same. This suggests that NASDAQ listed Chinese stocks are still cheap despite recent gains. And if you take a look at earnings growth of the three largest Chinese stock on the NASDAQ, (BIDU), NetEase (NTES) and Shanda (SNDA), it is clear that extraordinary earnings growth is behind each and every stock. Given that these three stocks make up over 50 % of total market cap for NASDAQ listed China stocks, the graph makes perfect sense.

But the chart is intriguing enough to make us wonder how does each component of the Chinese NASDAQ universe look from valuation point of view?


The first chart lines up the most liquid Chinese stocks based on total revenue. This is a chart that will place each component into perspective,. We all knew that online gaming generates more revenue than search in China and is well demonstrated on the chart.


Solarfun (SOLF) is the largest measured by revenue followed by Shanda Interactive (SNDA) and NetEase (NTES). By looking at the chart it is obvious that Solarfun and Baidu experienced the most stellar revenue growth in the last five years. The 9ltd (NCTY), Canadian Solar (CSUN), and (CYOU) look very impressive as well. (SOHU) and Sina Corp. (SINA), the two best known Chinese portals like, look matured with no significant revenue growth compared to other internet plays.

One of the most shocking trends belongs to Focus Media (FMCN), a company that experienced a remarkable growth till 2007 and then fell apart after selling most of its business in late 2008.


But as we know, revenues are important but profits are driving stock prices. For this reason we created a similar chart, a five year overview of net profits.


One of the most remarkable shifts from the revenue chart is that Solarfun (SOLF) is on the bottom of the list with significant losses in 2008. The other solar maker, Canadian Solar (CSUN) is in the red as well.

But NetEase (NTES) is the most profitable Chinese company from the NASDAQ and it looks like only or can challenge that position in 2009. (SOHU) shows a huge jump in profits for 2008 but it is attributable to a one time item, a spin-off of its online game unit. Sina Corp. is better reflecting the situation on the internet advertisement segment with a 30% jump in 2008 thanks to the Beijing Olympics.

Stocks with consistent earnings growth are limited to just a few companies. Fuqi International (FUQI), (CTRP),, and NetEase are members of this elite club and thus should be of the focus of seasoned investors.

To the contrary of stocks with quality earnings, Focus Media is the absolute loser with a huge net loss in 2008 combined with a weak outlook. Another stock to avoid is CDC corporation (CHINA), a company that is well in the red for 2007 and 2008.


Having filtered out the most interesting stocks, let’s see how do they measure from a valuation point of view.

The first chart on this page displays revenue and earnings growth for each stock sorted by current P/E. four stocks dominate the chart,, China Fire Security (CFSG), and The 9 Ltd. (NCTY). Baidu is trading at the highest P/E ratio but given her stellar revenue and earnings growth, high P/E looks justified. CSFG started out from a low basis, not sure what the future holds for this company. is similar but we think outlook is bright for the company and thus offers value at current low P/E. The9 Ltd. looks good but 2009 Q1 and outlook is keeping the stock price at bay.


The second chart on the page compared revenue and earnings growth of the past five years to stock price appreciation of the same period. is the most appreciated by the market followed by CFSG and is not showing stellar growth but started out from a high basis and proved to be consistent. (CYOU) is showing remarkable growth yet its price has not picked up yet. Looks like this company is a gem.


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