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Challenges and Opportunities for the Fall of 2010

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banace_4 September (Chinavestor) Hopes that August and early September will continue where July left off were shattered, as investors failed to find evidence that the global economic recovery would gain traction. At best, things just didn’t get worse...

High unemployment and an increasing number of foreclosures reminded investors that the recovery will be slow and gradual. While manufacturing data and the increasing number of payrolls showed signs of improvement, the overall economic picture in the largest economy of the world remains fuzzy. The Dow Jones Industrial Average (INDEXDJX:.DJI) lost 4.3 percent in August but bounced back in early September to pare losses for the year.

Chinese economic indicators are mixed as well; while industrial production picked up and the August trade balance was the third largest on record, policy makers expressed frustration with high property prices lashing out on the banking and real estate sectors. Investors stepped to the side fearing that a tightening in the financial system will hurt the fragile recovery. The Shanghai Composite Index (SHA:000001) went sideways since the end of July and continues to underperform all major international benchmarks with a negative 19.1 percent performance year-to-date.

Key stocks mentioned in this report include Sina Corp. (NASDAQ:SINA) and Sohu.com (NASDAQ:SOHU) from the interent space and Duoyuan Printing (NYSE:DYP) and Duoyuan Global Water (DGW).

 

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Hong Kong’s benchmark, the Hang Seng Index (INDEXHANGSENG:.HSI) has been tracking the Dow Jones Industrial Average (INDEXDJX:.DJI) the closest with a 2.3 percent drop YTD. The composite index, tracking Chinese stocks listed in the U.S., has lost 5.3 percent YTD. To say that 2010 has been a difficult year so far is an understatement.

To highlight difficulties all China stock advisors experienced, take a look at the front page of the “China Outlook 2010” report published by UBS AG at the beginning of December 2009. Not only did they miss the overall market direction but their stock recommendation went just as bad.

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We highlighted the list of the most preferred and least preferred stock list, dated December 2, 2009. While the recommendation was valid for the first six months of 2010, one thing is for sure: stocks that were supposed to rise for the January-June period skid; while stocks that were supposed to face disaster rose—except for China COSCO (HKG:1919). This stock actually fell 15 percent for the January– September period. While it may be an embarrassment for UBS, we take it more as evidence that stock picking for 2010 has been difficult, at best.

The problem is more on the economic level than on the stock level. For China, the problem stems from policy makers to rumors, sending the Shanghai Composite Index (SHA:000001) into wild swings. It looks like investors can’t take on additional risk, reacting to perceived or real bad news more vividly than to good news. Latest economic indicators suggest Chinese GDP growth for 2010 will remain above 10 percent and a soft landing is the most likely scenario for the economy. Domestic consumption is up, evidenced by August car sales growth three times that of July. Inflation is picking up due to food price increases and manufacturing remains robust, according to the latest report from the National Bureau of Statistics. August exports rose to the third highest on record, ballooning the trade deficit with the U.S. to surpass last year’s $227 billion.

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Now that economic outlook improved, Chinese policy makers ratcheted up rhetoric against high property prices again. Lending curbs took center stage on the agenda, punishing construction and financial sectors alike. These actions by policy makers rattled the nerves of risk averse investors, punishing the Shanghai Composite Index (SHA:000001).

For the U.S., investors need to believe that a sustained recovery is on the way. Looking at the latest economic data, from the housing market to manufacturing and unemployment, the overall picture is not as bad as many feared but is not enough to lift investors’ sentiment. Retail investors remain on the side with an attitude of “wait and see”. Lack of confidence in the recovery is partially to blame for the fall of the DJIA (INDEXDJX:.DJI) in August.

Yet the picture is different on the company level. Earnings in both countries remained robust, with a record number of Chinese companies reporting triple– and double-plays. By triple play we mean stocks that beat revenue and earnings estimates plus guided higher.

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While Chinese companies continue to deliver high revenue and earnings growth, investors turned their attention to the auditing aspect of Chinese companies. Corporate governance hasn’t been considered vanguard for Chinese companies for a long time, but the latest panic selling of Duoyuan Printing (NYSE:DYP) and Duoyuan Global Water (DGW) elevated the issue into a new level. Panicked investors sold off smaller cap Chinese stocks en masse, questioning the quality of bookkeeping for many.

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One of the shockers was that both Douyuan companies are NYSE listed, the cream of the crop. The NYSE is not responsible for such aggressive accounting, due diligence rests upon investment bankers, lawyers, and auditors among others. But damage is done by the fact that a Chinese company listed on the most prestigious stock exchange in the world is alleged in wrongdoing. On one hand it is unfortunate that a few companies, may be one or two percent of the total, that abused the trust of the investor community can tarnish the reputation of all U.S. listed Chinese companies.

Investors have to realize that crooks are in China, too—not just at Enron. When an American executive is caught wrongdoing it’s always just one man or a group of them. We don’t associate ourselves with those crooks. But when a Chinese executive is caught abusing the system, it’s so much more common to feel “it’s the Chinese”.

On the other hand, many argue, current turbulent times are serving the interest of quality Chinese stocks in the long run. It is better to send a message to all Chinese executives that there is zero tolerance policy in the U.S. when it comes to corporate governance.

Going forward, small cap stocks under market cap of $250 million threshold will find it more difficult to raise equity. These companies can’t afford to hire top four auditing firms, limiting their trustworthiness. Signs that capital gravitates toward larger names is evidenced by the recent surge of internet household names like Sina Corp. (NASDAQ:SINA) or Sohu.com (NASDAQ:SOHU). But once the dust settles, now under appreciated quality small caps will make investors very happy. The trick is increasingly difficult: separating darlings from the dogs.

Blaze Fabry

 

 



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