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China stocks and inflation

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money_3 May, 2011 (Chinavestor) Inflation in emerging markets continues to play a major role in China. We gave a title “Economic growth and inflation drive China stocks in 2011” to the February Newsletter, a statement that is just as relevant now as it was at the beginning of the year. While U.S. tech stocks have pushed the NASDAQ Composite Index (INDEXNASDAQ:.IXIC) to highs not seen since the dotcom boom in 2000, Chinese stocks continue to miss out. The Shanghai Composite Index (SHA:000001), an index measuring investors’ sentiment on the Mainland, fell 0.6 percent in April and is trailing the Dow Jones Industrial Average (INDEXDJX:.DJI) by a wide margin for the year. The Hang Seng Index (INDEXHANGSENG:.HSI), the most widely followed gauge of Hong Kong, eked out a small 0.8 percent gain for the month but is trailing even the Shanghai Composite Index for the year. The China ADR Index, a market cap weighted gauge for U.S. listed Chinese stocks, fared better for the month and YTD yet is still far below major U.S. indices.

Chinese internet stock IPOs continue to play a major role. Investors still remember the record IPO of SouFun Holdings (NASDAQ:SFUN) or the extraordinary run of Youku.com Inc. (NASDAQ:YOKU) after the IPO.  And the latest is just behind us - Renren Inc. (NYSE:RENN). But the newcomers pooped the party for established names like Sina Corp. (NASDAQ:SINA) or Sohu.com Inc. (NASDAQ:SOHU).

This Newsletter will examine trading opportunities for Melco Crown Entertainment (NASDAQ:MPEL) as well as liquid online gamers such as Changyou.com (NASDAQ:CYOU), Shanda Interactive (NASDAQ:SNDA) and Shanda Games (NASDAQ:GAME). The list wouldn't be full without NetEase.com Inc. (NASDAQ:NTES) Giant Interactive (NYSE:GA). Finally, Baidu.com Inc. (NASDAQ:BIDU) will be on the menu for inventors to gain from our perspective.

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The reason behind a lackluster performance of Chinese stocks globally is simple. Investors fear that in he wake of additional monetary tightening, the Chinese politburo may choke off growth. We don’t have to go far to find clues about the seriousness of Chinese policy makers when it comes to fighting inflation.

The Chinese Central Bank has lifted interest rates four times since October 2010. Additionally, it ordered major banks ten times to increase reserve ratio since the beginning of the last year.

As a result, reading of manufacturing growth in April was 52.9, down from 53.4 in March. But any reading above 50 indicates growth, something that is not the major concern of Chinese policy makers at this time.

To indicate the seriousness of the problem, investors have to go back in time. When the world financial crisis unfolded in 2008, Chinese policy makers introduced a $586 billion stimulus plan in November of that year. The result was the continuation of rapid economic development in China via aggressive lending. As the chart to the right shows, money supply (orange M2 line on the chart) and loans jumped while inflation was not a concern. But that all changed as the world came out of the recession and the excess money pumped in the economy had to be neutralized.

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And this task seems to be harder than originally thought. Despite a series of interest rate hikes and reserve ratio increases, and other administrative measures such as clamp down on second and third mortgages and caps on home prices in multiple cities, inflation have continued to increase. Some even fear that slower growth is the first sign of an upcoming hard lending, but that might be too much of a stretch. Nevertheless one thing is for sure: investors are expecting more monetary tightening on the road ahead.

One of the scary parts of high inflation is that most, if not all, of it originates within the country. The Chinese trade imbalance is radically smaller than the same time last year due to higher commodity prices, leaving the blame for high inflation on food prices.

The pressure is building on China to let the Yuan strengthen, releasing some of the pressure off inflation by lowering the cost of imports. Another indication of such scenario is the increase of China’s foreign reserves, reaching over $3 trillion for the first time in April. Observers point out that with a slightly positive trade surplus YTD, the growth in reverses doesn’t add up. The reason behind such influx may be speculative money, betting on a one time hike in the value of the Yuan.

While it’s not our task to predict what course China is going to take, e.g. continuing monetary tightening and/or letting its currency appreciate significantly, we will give investors clues how to benefit from such scenarios.

One of the most obvious steps could be a partial rotation out of China, should monetary tightening remain on the menu for a prolonged time.

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Looking at the performance of Chinese stocks in Asia and U.S. indices for the past six months, the difference in the direction is striking. While the Dow Jones Industrial Average (INDEXDJX:.DJI) surged 15.2% since November 1, 2010, Chinese indices went sideways at the best, as the following chart indicates.

But abandoning Chinese stocks, even for a limited time, would be a mistake. While most Chinese ADRs fell, a good number of them advanced. The trick remains to separate darlings from the dogs.

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We continue to believe that industry leaders with solid cash positions and constant revenue and earnings growth are the way to go. By looking at the best 20 performing Chinese ADRs during November 1, 2010 and April 29, 2011, we are proud to say that we identified eight of the top twenty during the examined period. No wonder, the growth portfolio is up 29.0% YTD, an extraordinary achievement given the hostile market environment. We made some mistakes, no doubt about it. We pulled the plug too early on Sina Corp. (NASDAQ:SINA), or failed to indentify the trading opportunity Melco Crown Holdings (NASDAQ:MPEL) represented. Nevertheless we have been identifying Chinese stocks with unusual growth potential, like China Unicom (NYSE:CHU), Changyou.com (NASDAQ:CYOU), Sohu.com Inc. (NASDAQ:SOHU) and Baidu.com Inc. (NASDAQ:BIDU) well before their rally was over. Our bet on the Chinese online game sector paid tangible dividends. We identified and featured Shanda Interactive (NASDAQ:SNDA) and Shanda Games (NASDAQ:GAME) months ahead of their recent surge, helping subscribers lock in gains. NetEase.com Inc. (NASDAQ:NTES) is another online gamer we continue to like. The resurgence of Giant Interactive (NASDAQ:GA) came as a surprise to us. And we’re still not sure if latest gains are sustainable. The company is going to report first quarter earnings on May 12 after the closing bell.

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The good news is that we not only identified stocks with upside potential but helped investors stay away from trouble as well. We have not recommended that investors buy any of the stocks listed on the right, a group of stocks with the worst performance over the past six months.

We have raised the issue of corporate governance and more importantly, the quality of the auditor. We argued that by the rule of thumb, Chinese companies under $250 million in market cap can’t afford a big four auditor, significantly increasing their risk level.

Another factor investors have to consider is how the Chinese company went public. I am not here to say that all reverse mergers ended up in disaster. But those that ended up in disaster lately went public through a reverse merger. Just think of Rino International, Tongxin Int. or Fuqi International.

On the other hand, an increasing number of Chinese internet related stocks have successfully IPOd with more on the pipeline. SouFun Holdings (NASDAQ:SFUN), Youku.com Inc. (NASDAQ:YOKU) or the largest Chinese social network site, Renren Inc. (NYSE:RENN) just today.

Going forward, let’s examine how to benefit from a scenario where the Chinese government lets the Yuan appreciate sharply.

Chinese airliners are primary beneficiaries of such an event for three main reasons. One, a stronger Yuan will make kerosene prices cheaper, a substantial cost reduction for a sector where over 60% of total cost is jet fuel. Two, debt service will be eased for airliners whose aircraft are denominated in dollars. And three, Chinese passengers will continue to pay in Yuan for the airfare, increasing the top line of the company is dollars. While airliners have been under pressure due to high oil prices, most of the decline has already been incorporated into their stock prices. This has created reasonable entry points for longer term investors. We continue to like China Southern Airlines (NYSE:ZNH) and China Eastern Airlines (NYSE:CEA) for the next six months.

Chinese telecoms are also going to benefit from a stronger Yuan. Anything with a significant domestic activity is considered good should the Chinese currency appreciate. But exporters and manufacturers will be hurt due to a stronger currency.

The solar sector, a major exporter, will feel a pinch on two fronts; cheaper energy prices will hurt demand in China and a strong Yuan will increase prices of PV panels abroad.

But the Yuan appreciation remains a big question mark for now, leaving investors with traditional tools to identify prime targets.

Blaze Fabry



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