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How to play Chinese stocks in the second quarter?

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think_1 April, 2011 (Chinavestor) March of 2011 was anything but a usual month. Not only did earnings roll in the fast lane but investors had to digest critical economic news from the U.S., China and Europe as well. On top of that agenda, events in the Middle East and in Japan added to the mix.

These latter two added to the price increase of oil not seen since 2008, hurting growth prospects for developed and emerging economies as well. Problems with the common currency of Europe continued to resurface with Portugal and Ireland in focus for the month.

The big mover for western investors for the month was U.S. economic, housing and job reports in this order. While many have a somewhat different spin on the numbers, the majority of investors see the glass half full rather than empty. The housing sector is not out of the woods yet, one of the sourest points of the U.S. economic recovery. But GDP growth has been promising with sound two months jobs creation on top of that. March saw the second month of over 200,000 jobs creation after February, a hopeful sign that GDP growth finally is trickling down to this critical element of sustainable economic growth. News sent the Dow Jones Industrial Average (INDEXDJX:.DJI) to a level not seen since June 2008, surpassing the Shanghai Composite Index (SHA:000001) and the Hang Seng Index (INDEXHANGSENG:.HSI) for the year.

Stocks mentioned in this Newsletter include China Life Insurance Co. (NYSE:LFC), China Eastern Airline (NYSE:CEA), China Southern Airlines (NYSE:ZNH) from the large cap NYSE listed China stock universe. ETFs are iShares FTSE/Xinhua 25 China Index (NYSE:FXI) and the Morgan Stanley China A Share Fund (NYSE:CAF). Smaller NYSE names include Mindray Medical (NYSE:MR) and Duoyuan Printing (NYSE:DYP). Selected auto stocks are China XD Plastics (NASDAQ:CXDC), Wonder Auto Tech (NASDAQ:WATG) and China Automotive Systems (NASDAQ:CAAS).


The Hang Seng Index (INDEXHANGSENG:.HSI) rose a mere 0.8% for March and is behind the Shanghai Composite Index (SHA:000001) YTD as well, after investors trimmed risk in the wake of the Japanese nuclear disaster.

The China ADR Index, compiled by Chinavestor, surged 3.8% for the month and has been catching up with the Dow Jones Industrial Average (INDEXDJX:.DJI). Most of the rise is due to energy and larger internet stocks for the index is market cap weighted.

Despite a slow start, the Shanghai Composite Index (SHA:000001) advanced 6.4% for the year, outperforming key indices of major emerging markets such as India or Brazil. Russia’s oil heavy weight market indices were hard to beat as price of the oil rose to levels not seen since 2008. Strong manufacturing data combined with slowing inflation suggest Chinese policy makers were able to put a break on price increases while keeping economic activity rolling. This bodes well for the Mainland index going forward, something that has implications for Chinese ADR trading as well.


Another boost for the Shanghai Composite Index (SHA:000001) came from the financial sector. Chinese banks have been increasingly profitable as the chart on this page suggests, far outpacing U.S. counterparts in terms of profits. China’s big four banks each netted more in 2010 than Wells Fargo (NYSE:WFC) or Goldman Sachs (NYSE:GS). This is in a sharp contrast to 2006 when both U.S. financial institutions returned more to shareholders than any Chinese bank.

What message investors in China take away from record profitability is this: despite government efforts to rein in inflation, economic activity –lending—remains robust. This is good news for skeptics who feared monetary tightening will choke off growth.

The question is this: how do U.S. based China stock investors benefit from the improving investment sentiment in Shanghai?

For one, China Life Insurance (NYSE:LFC) is a stock that benefits directly from such a scenario. We shunned the stock for the year but added it back to the Conservative Portfolio in April for the very same reason. China Life Insurance (NYSE:LFC) derives over 10 percent of its net income from investment related activities.

The iShares FTSE/Xinhua 25 China Index (NYSE:FXI) is the best way for investors seeking exposure to the Chinese financial sector. This is not only the most liquid Chinese ETF but more importantly is a financial heavy weight with over 50% of its assets coming from that industry. For a detailed breakdown of the composition of the ETF, visit out February Newsletter.

One of the best ways to track the performance of the Shanghai Composite Index (SHA:000001) is investing in another ETF: the Morgan Stanley China A Share Fund (NYSE:CAF).


There is a direct correlation between the two, as the chart above testifies.

But ETFs have historically been the low risk/low return type of investments for many, highlighting the need to find individual stocks with potential.

This is where earnings season comes to the help of intelligent investors. We all know that earnings drive stock prices—at least for the most part. Companies with constant revenue and earnings growth tend to outperform. This is why we give revenue and earnings growth history a paramount importance in finding value stocks.

One low profile stock we like on valuation is Mindray Medical (NYSE:MR). Revenue and profit for this Chinese medical equipment maker have been constantly growing over the past five years, yet the stock price have hardly budged. This is clearly demonstrated to the right, second chart from top. Part of it is an increased share count but that alone should not be enough to keep this stock from rising. The company has a market cap of $2.90 billion and ample trading volume.


Another stock that reported in March and is looking interesting is China Eastern Airline (NYSE:CEA) and its larger rival, China Southern Airlines (NYSE:ZNH). Revenue and earnings growth charts for these companies are found on the bottom of this page. There has been a clear mismatch between growth and stock price performance since January 2011. While both airliners reported record revenue and sound profits for 2010 and especially for the second part of the year, both ADRs fell hard YTD. There is an explanation for this—high oil prices will dent into profitability going forward—yet investors may want to give these companies a second look. Should tension in the Middle East subside, Chinese airliners will get back to favor fast. The growth in the top and bottom lines were driven by increased passenger and cargo traffic—albeit China Eastern Airlines (NYSE:CEA) incorporated smaller Shanghai Airlines to its books after the successful acquisition of that company earlier in 2010.



But NYSE listed stocks are not for everyone. Those that are looking for more risky and potentially better stocks, the NASDAQ is the playground. Take a look at another stock we’ve been following for some time: China XD Plastics (NASDAQ:CXDC). This Chinese car parts manufacturer reported after the close on March 31, beating 2010 full year analyst estimates and issuing outlook just below estimates. Despite a straight forward revenue growth and a hectic earnings growth with an upside trend, the stock has been falling. This suggests there is a mismatch between fundamentals of the company and its stock price, creating a trading opportunity.


But when it comes to stocks like China XD Plastics (NASDAQ:CXDC), investors have to go back to basics and ask themselves a serious question: how much risk are they willing to take? We all know that investing is risky. Adding China to the mix makes it even more risky. Going to small cap Chinese stocks is just straight gambling. Almost...

2010 has been an important milestone in the life cycle of Chinese listing in U.S. soil. The increasing number of small cap Chinese stocks booted from the NYSE and NASDAQ is alarming, something that’s worth paying attention to.

Wonder Auto Technology (NASDAQ:WATG) got hammered at the end of the month following allegations that it did cook books. Not only did this stock get hammered but so did the rest of the sector: China XD Plastics (NASDAQ:CXDC) and China Automotive Systems (NASDAQ:CAAS) as well. This fact highlights vulnerability of small cap Chinese stocks.

The problem is that it wasn’t just WATG that got its reputation tarnished. Advanced Battery Technologies (NASDAQ:ABAT) and China Integrated Energy (NASDAQ:CBEH) are fighting for survival on the NASDAQ right at the moment. And the list of NASDAQ booted PINKS listed Chinese stocks are on the rise: FUQI International just left the NASDAQ on March 30 following RINO, TXIC, XSEL,… Again, investors have to exercise extreme caution when it comes to smaller cap Chinese stocks!

And risk is not limited to the NASDAQ. NYSE listed Duoyuan Printing (NYSE:DYP) and Duoyan Global Water Inc. (NYSE:DGW) tumbled over 80% in the last 52 weeks following allegations similarly to China Education Alliance (NYSE:CEU).

Going forward, we recommend investors to invest in highly liquid, larger Chinese stocks—those that appear in our portfolios and weekly stock lists.

Blaze Fabry

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