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February 2010 Newsletter: Too much anxiety

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panic Feb. 1, 2010 (Chinavestor) January of 2010 was a month many of us would like to forget. The wound inflicted upon China stock investors cut especially deep for those, including us, who didn’t have defensive strategies in place. The lack of defensive play was a result of a bullish 2010 first six months outlook - an outlook we still stick to. Nevertheless short term corrections seem inevitable. Stocks mentioned in this report include:

Home Inns & Hotel Management (NASDAQ:HMIN), E-House Holdings (NYSE:EJ), China Real Este ETF (NYSE:TAO), Huaneng Power (NYSE:HNP), China Life (NYSE:LFC), Mindray Medical (NYSE:MR), Ctrip.com (NASDAQ:CTRP), Baidu.com (NASDAQ:BIDU), Yanzhou Caol (NYSE:YZC), Aluminum Corp. of China (NYSE:ACH), Sohu.com (NASDAQ:SOHU), Changyou.com (NASDAQ:CYOU), and JA Solar (NASDAQ:JASO).


The first two weeks of January continued where it ended in 2009. News that China relaxed investment rules and introduced short-selling and margin trading spurred investors optimism earlier in January. But signs that a correction may come around became real when Chinese policy makers started to signal an exit strategy from the stimulus driven rally later in January. It started out with the increase of target yield for one month Central Bank Note, the Chinese version of the T-bill in the U.S. Then policy makers have restricted loan placement, Bank of China issued long term bond to replenish capital, and directives were issued to banks requiring an increase in cash reserves. Fears that China might choke off growth sent Chinese stocks on a steady erosion.

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U.S. stocks went on a tailspin the same time following mixed earnings, a weak jobs market and a reality check that the economic recovery will be gradual and slow.

The DJIA fared better than her Chinese counterparts by shedding –3.5% for January vs. –8.8% for Shanghai Composite or –8.0% for the Hang Seng Index.

Many fear that we haven’t reached the bottom yet. Skeptics argue that the depth of the correction should be around –10% not just –6.1% the DJIA fell from her January high. Given that the +830 points or +8.6% advance of the DJIA in the November-December period last year was based on hollow optimism, the current decline has more downside potential left.

Despite recent correction, with all things considered, we remain bullish. Here is why.

Economic growth in the U.S. reached +5.7% in the fourth quarter. While we’re aware that some of it is due to inventory restocking and seasonal effects, the fact is that the U.S. is poised to outperform in growth most of the developed world in 2010. Strong economic growth is key in determining stock market performance and a sustainable strong growth is an excellent sign. While we’re aware of a historically high unemployment rate and a fact that jobs creation has been and is expected to remain sluggish for the rest of 2010, we see the glass half full rather than empty.

Looking at China, one of the most important factors to consider is economic growth; the basis for corporate earnings growth and a consequence of that stock price appreciation. GDP growth in China accelerated to +10.7% for the fourth quarter of last year and an accumulated +8.7% for year 2009, a very important factor.

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We’re fully aware of risks such as an accelerating inflation, the negative effects of early stimulus exit, fears from credit tightening and possible asset price bubbles. But we’re of a view that fears that a fiscal tightening in China will choke off growth are exaggerated and measures to cool off the economy by Chinese policy makers were not only necessary but of good judgment.

Considering that strong GDP growth has been driven by liquidity and not consumption, e.g. effects of the RMB 4 trillion ($586 billion) stimulus package, fiscal tightening measures to counter excess liquidity is a pivotal tool any central bank would consider as a first round of tools. Any major economy growing over +10% a quarter needs fiscal tightening, exactly what the Chinese have been doing since January.

Fiscal tightening tackles two more potentially harmful effects as well: accelerating inflation and asset price bubbles.

Regarding inflation, we don’t think it is a real concern just yet in China. As the following chart testifies, Chinese consumer price index (CPI) was +1.9% in December, still well below the average for the region. While the trend is not encouraging, CPI has started to grow in China in November 2009 after 13 months of decline and it has been accelerating since then; however, it is far from being a major concern at this point.

Regarding asset price bubbles, investors have over reacted in our view. We acknowledge that there are some legitimate concerns out there, but forces of change remain tamed.

One of the key drivers in asset price appreciation has been excess liquidity finding ways to property and real estate markets. Large industrial companies, flush with stimulus related cash, have been increasingly showing up in land auctions and have been grabbing commercial real estate. And while real estate prices have not exceeded 2007 level on an income adjusted basis, prices have been rising steadily throughout 2009. Policy makers have been extremely careful making sure not to do an overkill and brink the development of the sector to a standstill. First time home buyers still enjoy a deed tax cut to 1% but the business tax exemption on property sales have been restored to five years from two years in 2009.

Forces that drive the real estate sector remain intact and are expected to remain that way for the foreseeable future. These are strong investment demand and healthy financial condition of property developers.

Investment demand remain strong given the fact that China is roughly half way through her urbanization process. Demographics and labor mobility suggests demand for property developers will remain strong for at least the next five years.

The majority of Chinese real estate developers are financially healthy and have no incentive to sell real estate below market prices. If this is the case, we expect property prices remain firm for the first six months of 2010. After the slide in January, the sector trades at 10.5 times 2010 estimated PE, a very modest valuation in our view.

Stocks of interest for American investors are Claymore/AlphaShares China Real Estate ETF (NYSE:TAO), E-House (china) Holdings Limited (NYSE:EJ), and Home Inns & Hotels Management Inc. (NASDAQ:HMIN). All these financial vehicles are considerably oversold and offer entry positions at reasonable prices.

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Although January is the official start of the earnings season for Chinese ADRs, so far we’ve seen mostly pre-announcements. Here are some selected companies we pay close attention to:

Mindray Medical (NYSE:MR) guided 2009 revenues higher on January 11, 2010. Huaneng Power (NYSE:HNP) said it expects to swing back to profit in 2009 after significant losses in 2008. China Life Insurance (NYSE:LFC) said in a statement that net profit is expected to grow +50% in 2009 from a year earlier. But the slew of actual earnings will come as of February 1st with internet portal bellwether Sohu.com Inc. (NASDAQ:SOHU) and her online game unit, Changyou.com Ltd. (NASDAQ:CYOU). Travel industry leader Ctrip.com (NASDAQ:CTRP) will report the next day on

February 2nd. after the close. Search engine giant Baidu.com (NASDAQ:BIDU) will report on February 9 after the close, a very liquid but volatile company. JA Solar (NASDAQ:JASO) will open up the earnings season for the solar sector and her and LDK Solar’s (NYSE:LDK) earnings will be very closely watched.

Besides those stocks that we just highlighted, Yanzhou Coal (NYSE:YZC) and Aluminum Corp. of China (NYSE:ACH) are stocks we added to the portfolios last month. The basic assumption was that YZC and ACH will do well in a bull market, an assumption that proved to be right until bears took over in Shanghai. Assuming China’s growth story will give way to the bulls, ACH and YZC are back in business.

As we have been arguing the Chinese real estate market looks good right now on valuation. Solar stocks remain good on fundamentals, and we have to remind our readers that patience is a virtue.

Besides these particular stocks, we like companies that have strong cash flows, are industry leaders and boost solid fundamentals. Wish you successful investing, Blaze Fabry


China Stock 2009 Fourth Quarter Earnings Calendar

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