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Economic growth and inflation drive China stocks in 2011

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smart_1 February, 2011 (Chinavestor) The central theme for Chinese equities in 2011 is going to be economic growth and inflation. China, already the second largest economy in the world, churned out a 10 percent plus growth for 2010 with no signs of slowing down. But record earnings haven’t translated to stock price appreciation for the past twelve months as investors would expect. The Shanghai Composite Index (SHA:000001) was down for the past year, one major disappointment for many, and continued to remain soft in the first month of 2011 as well. The index fell 0.6% as a decline in resource and metal stocks outnumbered the gains of industrials.

While equity markets in mainland China suffer, U.S. indices continue to recover. The Dow Jones Industrial Average (INDEXDJX:.DJI) surged 2.7% for the month, its best January since 1997. Rising consumer confidence and blockbuster corporate profits are behind the rally.

The China ADR Index, compiled by Chinavestor, followed the DJIA very closely by a 2.4% rally. U.S. investors an keep eye on both countries with a bias toward U.S. markets. Index heavy weight large, integrated oil companies and internet stocks are responsible for the surge. Petrochina Co. Ltd. (NYSE:PTR), China's largest oil producer advanced 9.1% for the month while China Petroleum & Chemical Corp. (NYSE:SNP), the largest oil refiner in China, surged a record 15.35% for the month! (NASDAQ:BIDU), the largest NASDAQ listed Chinese stock, advanced 12.5% in January and added another 10% on February 1st. thanks to a gangbusters financial report.

Investors in Hong Kong had a reason to cheer as well as the Hang Seng Index (INDEXHANGSENG:.HSI) rose 1.8%.

Additional key stocks mentioned in this report include (NASDAQ:CTRP), Home Inns & Hotels Management (NASDAQ:HMIN), Trina Solar (NYSE:TSL), Ltd. (NASDAQ:CYOU) and Inc. (NASDAQ:SOHU).


So why the relative underperformance of Chinese stocks when their economy is growing faster?

The answer is monetary policy. While the FED continues to maintain a loose monetary policy, trying to stimulate the economy, Chinese policy makers are concerned about inflation and suggest more tightening is on the way.

To understand the current situation in China, we have to go back to early 2008 when China unleashed a $586 billion stimulus program to counterweight the global economic slowdown. Aggressive lending prevented China from an economic slow down but the time has come to soak up excess liquidity before inflation spins out of control.

As the following chart testifies, inflation has been on the rise for all of 2010 in China and while not in dangerous levels yet, policy makers have stepped up efforts to contain it.


Looking at inflation closely, it appears that food prices have led inflation, something that Chinese policy makers watch very closely. While higher food prices raise disposable income for rural residents and spread wealth to the western parts of the country, the rise have to be in check to avoid social unrest.

To tame inflation, Beijing has repeated the following steps throughout 2010 and in 2011:

  • Raised interest rates.
  • Raised bank reserve ratios.
  • Raised down payment requirements for second and more homes.

With inflation still at the high end of the desirable range, investors fear more monetary tightening is going to happen, hurting outlook for equities.

Putting Chinese inflation into perspective, we have to consider that the inflation target is under 3% in the U.S. and the Euro zone. But China seems to have accepted the high growth rate with higher inflation scenario.

This leads us back to growth. Anybody who has been travelling to China lately knows, that there are no signs of slowing down or any reminiscence of recession, which most of the world experienced since 2008. Businesses are booming, infrastructure build up remains impressive while self-made millionaires continue to spring up more businesses. Cars now jam Beijing's road to a point that the city took away the title as “the largest parking lot” from the Long Island Expressway.

So opportunities exist. The trick is how to find them.

The good news is that corporate earning growth for Chinese firms has been extremely strong.

Internet giant Inc. (NASDAQ:BIDU) surged 9.30% today after a triple play: the company reported revenues and net income which substantially exceeded the expectations of the analysts. As the chart to the right testifies, China’s dominant search engine company has been steadily growing both in terms of revenues and net income.

Another good news came from Ltd. (NASDAQ:CYOU), a Chinese online game developer and operator. The story is very similar to that of Inc. (NASDAQ:BIDU), except for that lack of price appreciation in the past. We have noticed the yawning gap between earnings growth (red line on the second chart) and stock price appreciation (yellow line), or rather lack of it. Shares of the company jumped over 10% and 15% for two days following earnings announcement, its best two day gains for years.

NL_2011feb_3 Inc. (NASDAQ:SOHU), former parent of Ltd. (NASDAQ:CYOU) that still retains over 50% of its shares and thus incorporates CYOU’s numbers into its books, reported sound growth but guided somewhat lower for the upcoming quarter. Nevertheless all these companies made investors happy lately, something that we expected. Seasoned investors recall that we had Ltd. (NASDAQ:CYOU) and Inc. (NASDAQ:BIDU) in the Growth portfolio for January, both delivering excellent returns for the month.

Besides internet stocks, pre-announcements from various NYSE listed Chinese stocks look very promising as well. Aluminum Corp. of China (NYSE:ACH), the third largest maker of the metal in the world, estimated that it would return to profitability for 2010. News sent shares of the company soaring earlier in the month. Both NYSE listed Chinese airliners, China Eastern Airline (NYSE:CEA) and China Southern Airlines (NYSE:ZNH), delivered highly optimistic 2010 preliminary numbers. Both airliners said that their profits would increase over twenty five fold, albeit from a low base. Considering that 2010 was a highly successful year for airliners globally, Chinese airliners seem to be sound investments at current prices.

The less impressive results so far are limited to two companies: New Oriental Education & Technology Group (NYSE:EDU) and CNOOC ltd. (NYSE:CEO). The former is the leader in the education sphere that reported dismal fourth quarter numbers. That, combined with a class action law suit against China Education Alliance (NYSE:CEU), bodes ill for the sector.

The second corporate weakness came from CNOOC Ltd. (NYSE:CEO), China’s offshore oil specialist. The company disclosed a growth strategy for 2011 to the dismay of investors.

Looking forward, we are optimistic about the following sectors: internet, travel/leisure, and energy.

We continue to like Inc. (NASDAQ:CTRP) and Home Inns & Hotels Management (NASDAQ:HMIN) from the NASDAQ. Both companies have healthy balance sheets and have delivered sound revenue and earnings growth.

Chinese airliners are trading at a discount in our view and offer investment opportunities at current prices. We prefer China Eastern Airlines (NYSE:CEA) for its larger exposure to international flights over China Southern Airlines (NYSE:ZNH). While high oil price is a concern for the sector, should the crisis in Egypt get resolved, both airliners may see a hefty price appreciation.

Guangshen Rail (NYSE:GSH), the only Chinese railway company listed in the U.S., offers exposure to China’s bullet train network. The company operates in China’s economic heartland, the Pearl River delta, and operates a stretch of the high speed train linking Guangzhou with Wuhan as well.

The Chinese energy sector has been full of opportunities. High oil price boosted earnings of U.S. and Chinese energy giants, respectively. We mentioned Petrochina Co. Ltd. (NYSE:PTR) and Sinopec (NYSE:SNP) earlier in the Newsletter. Both oil companies had a tremendous run in January yet more upside looks possible. CNOOC ltd. (NYSE:CEO), a pure oil producer, is a no-brainer beneficiary of record oil prices but is susceptible to correction after a non-impressive 2011 growth pan.

Yanzhou Coal Mining (NYSE:YZC), the fourth largest Chinese coal miner, enjoyed a very strong fourth quarter last year but fell in January on valuation. Investors have to exercise caution going forward here.

The Chinese solar sector is just as interesting. We had Trina Solar (NYSE:TSL) and LDK Solar (NYSE:LDK) in the portfolios for January with great results. The sector got a significant downgrade at the end of the year from a Citi analyst, predicting overcapacity and falling margins. The subsequent sell-off created opportunities for the intelligent investor for January. Going forward, we remain bullish of the sector based on fundamentals. Demand for solar energy remains strong and given current margins and factory output, we think the sector is very attractive as the earnings season closes in.

The real estate sector is less interesting in February as it was before. More tightening on the sector will prevent the sector from a break out.

We continue to like SouFun Holdings Limited (NASDAQ:SFUN) though for its business model and strong financials.

Chinese industrials are attractive on valuation and economic growth, like China XD Plastics (NASDAQ:CXDC) and Mindray Medical (NYSE:MR). Both companies have upside potential should latest financials impress investors.

Finally, 51job Inc. (NASDAQ:JOBS), has had a record 2010 year that may stretch well into 2011.

Wish you successful investing

Blaze Fabry


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