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Concentrate on risk, not return

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risk_1 November, 2011 (Chinavestor) I am sorry for the late transmittal of this Newsletter, which was caused by the severe power outages in Connecticut.

October was the best month for many indexes for the year. The Hang Seng Index (INDEXHANGSENG:.HSI) surged 14.2% after a similar drop a month earlier. The Shanghai Composite Index (SHA:000001) advanced over 6% in October and an almost 10% advance of the Dow Jones Industrial Average (INDEXDJX:.DJI) pushed it back to positive territory for the year.

Large cap, index heavy U.S. listed Chinese stocks sat on a sideline, but technology, transportation and basic material stocks made a real comeback. Stocks on the move included Inc. (NASDAQ:BIDU), Inc. (NASDAQ:SOHU) and Ltd. (NASDAQ:CYOU) from the internet sector. Suntech Power (NYSE:STP), Trina Solar (NYSE:TSL) and LDK Solar (NYSE:LDK) is mentioned in this Newsletter in the second half. Also, New Oriental Education (NYSE:EDU), E-House Holdings (NYSE:EJ) and Yanzhou Coal Mining (NYSE:YZC) are stocks of interest.



Looking forward, investors have to cope with a huge politically driven economic risk from Europe on top of corporate and economic news.

Earnings season is full on when it comes to corporate news. Two industry leaders reported early in October, Inc. (NASDAQ:BIDU) and New Oriental Education Corp. (NYSE:EDU). While EDU reported sound revenue and earnings growth, it was Inc. (NASDAQ:BIDU) that stole the show. China’s search engine giant reported a classic triple play again, beating consensus revenue and earning numbers and issuing Q4 revenue guidance above estimates. But Inc. (NASDAQ:SOHU) and Ltd. (NASDAQ:CYOU) fell hard on Monday after reporting sound revenue growth but missing earnings estimates. Chinese telecom, airline and energy stocks all reported in October, leaving the show down to NASDAQ listed smaller stocks for the month of November.

When it comes to the European Union, some say we’re sitting on a ticking time bomb, ready to explode any minute. Actually, timing got a little easier considering the maturity of Greek loans as the following chart displays. November is going to be relatively painless with a €3.7 billion payment but that’s nothing in comparison with a €11.9 billion due in December. The referendum thus is very timely right before those loans are due, sometime in the first or second week of December. This is when investors will have a much better understanding where the European common currency is heading.


As we have argued in several articles in the past, Greece’s ills present problems way beyond its tiny economy. Should Greece leave the Euro-zone and re-introduce the drachma at a significant discount, euro deposits in Greek banks would have to be converted to drachmas at a discounted rate. This was the case with Argentina and is the most likely scenario Greece would adopt. That would force ordinary citizens with savings in Greek banks to swallow steep losses. Who could then stop the Irish, Portuguese and the Italians to withdraw all their savings and more (credit cards) and deposit them in Germany to safeguard against such eventuality? That will surely blow apart Italy’s banking system that will in turn provide a fatal blow to the European common currency. Fears of such eventuality have already pushed the spread between German and other European government bonds to record highs.


A beak-down of the European monetary union would temporarily dislodge markets at the minimum, causing additional economic slow down in Europe and the rest of the world.

Ironically, the European Central Bank has had a tool at its disposal to avert the debt crisis. The bank is not limited by its balance sheet to keep buying Greek and other peripheral countries’ bonds to keep them afloat. The whole sovereign debt crisis would have been history if the ECB had acted. But that may come just too late now should Greek voters reject the whole bailout altogether and opt out of the eurozone.

Remember, the EU is the largest trading partner of China, a market that drives whole sectors in China like solar manufacturers. In fact, a worsening European outlook for solar panels are primarily responsible for the steep declines in the value of Chinese PV manufacturers. Suntech Power (NYSE:STP), Trina Solar (NYSE:TSL), LDK Solar (NYSE:LDK) fell close to 80% in value YTD as the chart below testifies.


But investors know that ultimately revenue and earnings growth, or a lack of it, drive stock prices. Chinese tech stocks from the internet space gave testimony of that old cliché again. Inc. (NASDAQ:BIDU) is China’s Google Inc. (NASDAQ:GOOG), constitutes over 80% of China’s search traffic. The company is not only successful in increasing its market share at the expense of its rivals but is successful in turning revenue growth to profit growth as well. Investors loved that the profit margin for Inc. (NASDAQ:BIDU) stayed firm above 45% for the last quarter.

But things were different for Inc. (NASDAQ:SOHU), China’s Yahoo! (NASDAQ:YHOO). While revenue growth was comparable to Baidu’s, net income growth lagged as profit margins soured. In fact, profit margin for Inc. (NASDAQ:SOHU) has eroded from 25.7% in the first quarter of this year to 20.1% by the third quarter. Investors took note of it and sold off shares of the company.


This is a reminder that top line growth is not enough. Chinese companies have to deliver earnings to see stock price appreciation.

It is even more so in times of uncertainty. Europe has still to figure out a way to get out of the current sovereign debt crisis. That risk alone has been responsible for much of the volatility in October and will hang over equity markets for the rest of the year. That said, investors have to concentrate on risk not on return.

One of the most accepted ways to measure risk of individual stocks is calculating beta, a stock specific number that tells investors how well a stock correlates with the market itself. When beta is one, that means a stock moves perfectly in-line with the market. When beta is less than one, that means a stock moves less then the market. Visa verse, when beta is above one that means a stock moves more than the market. Obviously, higher the beta the more volatile a stock.

The chart below lists the most frequently traded Chinese stocks by beta. Chinese telecoms, utilities and selected online gamers have betas under one. In fact, Chinese telecoms have provided a cushion when markets tumbled but failed to gain traction when investor sentiment improved. Chinese telecoms continue to be a sector of choice for risk averse investors. Inc. (NASDAQ:NTES), 51job Inc. (NASDAQLJOBS) or Inc. (NASDAQ:SOHU) are the least risky technology stocks. But solar stocks, basic materials and transportation stocks are for the risk takers for their fortunes may change quickly. High return comes with high risk, a cliché that remains very true under current market conditions.


Investors looking for return should consider Inc. (NASDAQ:BIDU), E-House Holdings (NYSE:EJ) and Yanzhou Coal Mining (NYSE:YZC) besides solar, transport and resource stocks. Wish you successful investing, Blaze Fabry.

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