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July 2010 Newsletter: Rock bottom China stocks offer bottom fishing

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bottom_fishing_1 Losses have accelerated at the end of June sending the DJIA (INDEXDJX:.DJI) 2.5 percent lower for the month and over ten percent lower for the quarter. The Shanghai Composite Index (SHA:000001) fell to 2,398 points, a new 52 week low, on June 30, 2010. The index is off 26.8 percent year-to-date (YTD) and is second only to the 35 percent dive Greece's stock index experienced in 2010.

The Hang Seng Index (INDEXHANGSENG:.HSI) fared better, gaining 1.8 percent for the month but is still down 8 percent for the year. The China ADR Index, a composite measuring the performance of U.S. listed Chinese ADRs, tracked U.S. markets lower for the month as well as for the year.

Stocks mentioned in this report: Baidu.com (NASDAQ:BIDU), Ctrip.com (NASDAQ:CTRP), and Shanda Games (NASDAQ:GAME) from the internet sector. China Telecom (NYSE:CHA), China Mobile (NYSE:CHL) and China Unicom (NYSE:CHU) from the telecommunications sector. Sinopec Shanghai Petrochemical (NYSE:SHI), China Petroleum & Chemical Corp. (NYSE:SNP), and Yanzhou Coal (NYSE:YZC) and Huaneng Power international (NYSE:HNP) from the energy sector. China Eastern Airlines (NYSE:CEA) and Home Inns & Hotels Management (NASDAQ:HMIN) from the leisure/travel industry.


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Dismal jobs creation and unexpected rise of jobless claims at the end of the month highlight the difficulties that lay ahead. And while problems persist, bottom fishers point out that Chinese stocks are now trading at favorable valuations. Some even argue that a strong rally is ahead for the rest of the year.

The following concerns have been driving China stock investors in 2010 so far: China's exit from stimulus, slower manufacturing growth, asset price bubbles, fiscal tightening and the uncertainty surrounding the Yuan revaluation.

The stimulus exit is not only welcome but is necessary because excess liquidity resulted in excess capacity and real estate speculation. Money supply is going to be influenced the most by the stimulus exit while consumer durables –like autos—will continue to benefit from extended subsidy schemes.

The other concern is slower manufacturing growth. Growth in China's manufacturing sector cooled more than expected by economists in June, fueling fears that the global economic recovery still has a long way to go and stoking concerns that economic growth in China, the world's fastest growing major economy, will not be as robust as previously expected.

China's Purchasing Manager's Index fell to 52.1 in June from 53.9 in May, the second monthly decline. The news sent Asian stocks tumbling as investors continue to fret over the toxic combination of waning Chinese growth and Europe's sovereign debt woes, two issues that have punished global equity markets this year.

Goldman Sachs (NYSE:GS) said part of the decline in the June manufacturing number may be attributable to seasonal factors as the June reading is typically lower than the May reading. Inventories in China are rising as export demand is slumping and domestic demand is faltering. Europe is the top end market for Chinese-made goods, accounting for 20% of Chinese exports.

Analysts expect GDP growth of 8% to 9% for China in the second half of this year following the stellar 11.9% jump in the first quarter.

Another worrisome factor is China’s asset price bubbles. While there is no-one to tell how big the bubble is, one thing is for sure: residential property prices have been on the rise since November 2008, the time China unleashed the Yuan4 trillion ($586 billion) stimulus package. According to official statistics, property prices rose 13 percent in the last 12 months while unofficial estimates put it to 25 percent. However investors tend to forget some very important China specific factors concerning the real estate situation. For one, two thirds of China’s population, an estimated 800 million people, still live in rural areas. They are essentially farmers whose income has been on the rise due to increasing food prices and improved agricultural methods. A large portion of this class is eager to move to the cities, sustaining a huge underlying demand for housing. With increasing disposable income and savings, the surge in demand is fundamentally solid. Should apartment prices drop 20 percent, for argument’s sake, a large number of additional farmers will enter the market. With a huge underlying demand, a collapse of the property market is not an option.

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Another factor to consider is the mortgage structure in China vs. the U.S. There has never been a zero down, sub-prime loan in China. Prospective buyers have to put down 30 percent or more for down payment, deterring pure speculative investors from entering the market.

And finally, China’s economy is much more export oriented than that of the U.S. Consumer spending is responsible for 75 percent of GDP growth in the U.S., making it much more sensitive to property price fluctuations. So should real estate price deflation hit China, a scenario we think is highly unlikely for above mentioned reasons, the effect of such event will have a much smaller impact.

Fiscal tightening is not a real danger at the moment, inflation in China is around 3 percent this year, within the official target rate. Most of the rise is due to food price increases while core inflation remains relatively slow at 1.3 percent.

The Yuan revaluation is not a threat but an opportunity for equity investors. We have seen the impact of such a scenario on June 21, Monday when global indices soared following news that the end of the Yuan-dollar peg is near. While a sobering up followed the announcement the subsequent days, the prospect of a stronger Yuan is real and will have a positive impact on equity markets world wide.

We’re of a view that global economic concerns have obscured investors from looking at the company level pushing valuations to attractive levels.

According to the latest statistics, Chinese stocks are trading at bottom low prices and all they need is just a catalyst—like the Yuan revaluation. Chinese ADRs are trading at 17 times earnings on average, a drop of 30 percent from a year ago.

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One of the best looking companies on valuation is Huaneng Power (NYSE:HNP). The company reported robust first quarter results and a May generation rate above estimates. As the subsequent chart testifies, Huaneng Power Int. (NYSE:HNP), the largest independent power producer in China, has been profitable since early 2009 yet its stock price has been virtually unchanged. Another positive development for the short term is soft coal prices. Not only does coal price follow that of the oil in China but the government “asked” coal producers not to raise coal prices in the summer. While this is bad news for Yanzhou Coal (NYSE:YZC), the only NYSE listed Chinese coal miner, power producers enjoy the break.

Sinopec Shanghai Petrochemical (NYSE:SHI), the largest Chinese polyethylene and polypropylene producer, is benefitting from soft oil prices as well. While demand remains strong for its products the company gets its raw material at a relative bargain, boosting its margins. The same is true to a lesser extent to China Petroleum & Chemical Corp. (NYSE:SNP), known and Sinopec. Asia’s largest refiner by volume is benefitting from lower crude prices while gasoline prices at the pump are less effected.

The Yuan revaluation boosts Chinese domestic plays. The telecom sector, railways and airliners have been enjoying a ride lately.

China’s State Council announced plans to boost infrastructure spending for 2010-2020 focusing on the high speed rail network. Plans are laid for a 16,000 km long network of high speed rails travelling at 350 km per hour (220 mph) between urban centers. The first major project connecting Guangzhou to Wuhan cut travel time to three hours effectively competing against China Southern Airlines (NYSE:ZNH), Hainan Airlines and Shenzhen Airlines.

Guangshen Rail (NYSE:GSH), a rail network operator in the Pearl River Delta region, opened up its first high speed rail connecting Guangzhou to Shenzhen, cutting travel time under one hour.

China Eastern Airlines (NYSE:CEA) is less effected by the competition. Thanks to the Shanghai Expo, an exhibit attracting tens of millions of visitors up until November, China Eastern Airlines (NYSE:CEA) is in a sound position to cater for visitors via its major hub in Shanghai. The absorption of Shanghai Airlines is going on smoothly giving CEA an over 50% market share in Shanghai’s airports.

Chinese telecommunication firms look good ahead of the Yuan revaluation. A stronger Yuan means that earnings in the Chinese currency will translate to more profits in dollars, thus boosting its ADR price in dollars. We have noticed increasing volume and price appreciation for China Unicom (NYSE:CHU), but China Mobile (NYSE:CHL) and China Telecom (NYSE:CHA) are attractive value plays at the moment as well.

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We continue to like Home Inns & Hotels Management (NASDAQ:HMIN). The company reported record first quarter revenues and sound profits with improved outlook. While the company is trading at a 52 weeks high the chart testifies that prices have been higher in the past. The company is going to report 2010 second quarter earnings in early August , something we’re going to watch very closely.

We continue to like online game developers and operators from the NASDAQ listed China stock universe. Shanda Games (NASDAQ:GAME) and NetEase.com (NASDAQ:NTES) have been hit very hard in 2010 so far, both stocks are trading at a 40 percent discount compared to December 2009 prices. We’re of a view that industry leaders are going to lead the sector higher, making both companies attractive at current prices.

Baidu.com (NASDAQ:BIDU) and Ctrip.com (NASDAQ:CTRP) are Chinese blue chips that we find attractive. Both companies are cash rich, have been growing at a high growth rate while maintaining the industry leader position.

Chinese solar stocks suffer from the weak euro and soft energy prices but offer true value for the 3 months plus period.

Blaze Fabry

 



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