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Aug 2010 Newsletter: Earnings drive stock prices while economy recovers

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strong Timing the market is always difficult nevertheless our last Newsletter, titled “Rock bottom China stocks offer bottom fishing” was a home run. We wrote that “… Chinese stocks are now trading at favorable valuations. Some even argue that a strong rally is ahead for the rest of the year.”

While some of the concerns responsible for pushing the Shanghai Composite Index (SHA:000001) 27 percent lower for the first six months of the year persist, investors have turned their attention to earnings prospects and government fiscal policies in July.

Other key indices mentioned in this report include the Dow Jones Index Average (INDEXDJX:.DJI) and the Hang Seng Index (INDEXHANGSENG:.HSI). Key stock of the report are not limited to Trina Solar (NYSE:TSL), Yingli Green Enrgy (NYSE:YGE), Solarfun Power Holdings (NASDAQ:SOLF) and JA Solar (NASDAQ:JASO) from the solar sector plus Sina Corp. (NASDAQ:SINA), Ctrip.com (NASDAQ:CTRP), and Home Inns & Hotels Management (NASDAQ:HMIN).

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The result was a 11 percent rally for the Shanghai Composite Index (SHA:000001) and a just as impressive 7 percent advance for the Dow Jones Index Average (INDEXDJX:.DJI). This marked the best month for the Chinese benchmark since last July when it rallied 15 percent, and the best month for the DJIA in 2010.

While the DJIA is back in the black for year-to-date, every major Chinese index is still under water, as the following chart testifies. The Hang Seng Index (INDEXHANGSENG:.HSI) fares the best YTD among the Shanghai Composite Index (SHA:000001) and the China ADR Index with a 3.9 percent loss for the year, while the Shanghai Composite is still down 19.5 percent. U.S. listed Chinese stocks tend to correlate with the Hang Seng Index, shielding western investors from steep losses for the year.

Both markets, China and the U.S., have seen strong corporate earnings despite some weak spots in the macro economy. While trends and latest developments in regards to the U.S. economy are well known for western investors, China is a different story.

We have analyzed the five most pressing economic issues for Chinese investors in the previous Newsletter. These were stemming from the exit from stimulus through slowing manufacturing growth, asset price bubbles, fiscal tightening to the Yuan revaluation.

What seems to be the most important driver for Chinese stocks in July was fiscal tightening, or rather the lack of it. Most retail investors in China still believe the government pulls the ropes when it comes to the stock market and the “herd behavior” has long became a key driver for the Shanghai Composite Index (SHA:000001). Key policy makers, including Chinese Premier Wen Jiabao, have hinted numerous times in July that fiscal tightening and the crack down on property prices will be relaxed to counterbalance slowing manufacturing activity and economic growth. In-line with the politburo, the Central Bank of China left interest rates unchanged despite rising rates all over the region, from Australia to Korea and India. The shifts in economic policy have helped to restore investors’ confidence and the bulls grabbed the horn of the market.

The month of July saw another fear factor diminish; export slow down to Europe. Given that China’s largest trading partner is the European Union, the weakness in the Euro and a credit crisis put Chinese investors on the defense. But European banks have passed the stress-test and latest customs data suggests that China’s export oriented industries don’t feel a pinch from slower global growth.

China’s GDP growth forecast has been lowered to just over 10 percent for 2010, suggesting the government will keep key elements of the stimulus program in place for the rest of the year. With a relatively loose fiscal environment and government spending in public housing and tax incentives to spur domestic consumption, Chinese investors have started to reenter the market.

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Despite a slower growth for 2010, China has just surpassed Japan as the second largest economy in the world in July. While the size of China’s GDP was $4.98 trillion in 2009 just below that of Japan’s $5.07 trillion, even a ten percent growth for China means a $5.48 trillion economy by the end of the year compared to Japan’s $5.22 trillion, assuming a 3 percent growth for the island nation. The U.S. boosts still by far the largest economy though its advantage is slipping.

When it comes to successful investing, it is good to be in touch with the big picture. At least we have a decent level of confidence that the markets are not going to collapse. But it is earnings that ultimately drive stock prices and August is going to be a bonanza for China stock investors. We have seen some key Chinese companies reporting 2010 second quarter earnings in July but the vast majority is just coming on stream.

What we have seen so far is rather encouraging. Take a look at two prominent internet stocks; Baidu.com (NASDAQ:BIDU), the largest Chinese search engine company, and Sohu.com (NASDAQ:SOHU), the fourth largest web portal.

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Baidu.com (NASDAQ:BIDU) blew past expectations, beating revenue and earnings consensus by a wide margin. Analysts were expecting second quarter revenues of $239.4 million when Baidu upped the range to $268 million—$270 million on April 28, 2010. So the $282.3 million actual number beat expectations handsomely and so did actual earnings of $123.1 million vs. consensus estimate of $104 million. Apparently Baidu.com (NASDAQ:BIDU) was able to benefit the most from Google’s departure from China , adding a record number of new customers while traffic acquisition costs fell. Besides beating revenue and earning estimates, the company upped its third quarter outlook, making it the first Chinese “triple play“ of the season. Looking at historical revenue and earnings growth, the current stock price looks in-line with the overall growth trend. Nevertheless the stock continues to trade at 87 times earnings, a very high valuation, which makes the stock vulnerable to a negative correction should the growth rate show signs of exhaustion.

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Sohu.com (NASDAQ:SOHU) is the other prominent internet stock that is worth paying close attention to. Financial report of the fourth largest web portal helps investors to gauge the dynamics of the all important advertising revenue segment. Sohu.com (NASDAQ:SOHU) beat revenue and earnings expectations as well and issued a sound outlook for the upcoming quarter. The company reported revenues of $146.1 million vs. consensus estimate of $139 million—$144 million while earnings came out to $.87 per share vs. estimates of $.83 per share.

While historical performance doesn’t guarantee future stock price moves, when industry leaders outperform, the rest of the market tends to follow. This is why investors have a fair level of confidence into Sina Corp’s (NASDAQ:SINA) earnings coming up on August 4, Wednesday after the close.

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Strong results from internet stocks helped propel online game stocks for the second part of July. Th9 Ltd. (NASDAQ:NCTY) jumped 25 percent followed by NetEase.com Inc. (NASADAQ:NTES) and Shanda Games (NASDAQ:GAME). Considering that only NetEease.com Inc. (NASDAQ:NTES) is in the black for 2010 among online game developers and operators while Shanda Games (NASDAQ:GAME) is trading 35 percent lower. This one looks like it is trading at a discount.

Another hot sector we have been following is Chinese solar makers. While investors have witnessed a 20 percent plus price appreciation in the past two months for Trina Solar (NYSE:TSL), Solarfun Power Holdings (NASDAQ:SOLF), Yingli Green Energy (NYSE:YGE) and JA Solar (NASADAQ:JASO), more upside is possible should earnings beat expectations. Solarfun Power (NASDAQ:SOLF) is going to report on August 3, Tuesday, before the open, setting a stage for the rest of the sector. JA Solar (NASDAQ:JASO) is schedule for August 10 before the open followed by Trina Solar (NYSE:TSLK) on August 16. Investors have to realize keep in mind two factors: for one, solar makers have returned to profitability as of the end of 2009 and have been operating with relatively firm operating and profit margins. This positive development will be muted by the weaker euro in the second quarter of the year. Nevertheless rising demand, increasing shipment of PV modules combined with firm margins sound like a good recipe before the opening of the solar earnings season.

Besides Sina Corp. (NASDAQ:SINA) and the solar sector, I suggest you take a closer look at Ctrip.com (NASDAQ:CTRP), Home Inns & Hotels Management (NASDAQ:HMIN), and E-House Holdings (NYSE:EJ). These companies have strong track records of revenue and earnings growth, something that increases the level of confidence that they will do well, again. Ctrip.com (NASDAQ:CTRP) is scheduled for August 9 after the close, followed by Home Inns & Hotels Management (NASADAQ:HMIN) the following day. E-House Holdings (NYSE:EJ) will report on August 11 before the market open. While Ctrip.com (NASDAQ:CTRP) and Home Inns & Hotels Management (NASDAQ:HMIN) are not cheap, trading at 53 times and 47 times earnings, respectively, E-House Holdings (NASDAQ:EJ) and Sina Corp. (NASDAQ:SINA) go for 12 and 6 times earnings at the present.

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