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Focus on quality of Chinese stocks

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bull_bear_4 April, 2012 (Chinavestor) It paid to be conservative in March. While the Dow Jones Industrial Average (INDEXDJX:.DJI) eked out a 1.8% gain for the month, Chinese indexes collapsed. The Shanghai Composite Index (SHA:000001) fell as much as 7.7% in just one month while the Hang Seng Index (INDEXHANGSENG:.HSI) registered a 4.7% decline. The good news is that we warned investors about the possibility of an upcoming correction. This is why we gave “What if technicals drive the market” title to the previous Newsletter. We pointed out that indexes world wide ran up too much, too fast and if technicals were to drive markets, a correction was coming.


When indexes rise to four years highs, as is the case with major U.S. indexes, investors tend to lock in profits. Others are looking for an excuse to start a sell-off. And China provided that excuse.

First, Chinese officials lowered the GDP growth target rate to 7.5% from 8.0% for 2012. Then a record trade deficit number, slowing inflation and decelerating manufacturing data followed. Some investors went on a buying binge in anticipation of an upcoming easing policy. Instead, Chinese Premier Wen Jiabao insisted that property curbs were to stay because real estate prices were considered too high by the politburo. The last nail in the coffin for the month was a Soc Gen report, predicting that profit growth for Chinese state owned enterprises will be zero for 2012.

The composite of U.S. listed Chinese shares, compiled by Chinavestor, still showed a handsome 3.4% gain for the month. But March wasn’t a cake walk for U.S. equity markets, because volatility for the Dow Jones Industrial Average (INDEXDJX:.DJI) noticeably increased in the second part of the month as the chart on the previous page testifies.

There are some notable changes in the reason for nervousness. For one, Europe and its economic problems went from front page to hiding. There is no indication that Europe left its sovereign debt crisis behind itself and bad news is expected to pop up from time to time. Nevertheless investors gave up on understanding the complexity of European decision making process and ignored most of the news in March.

Two, China came to the forefront in the global economic arena with clear signs of a slow down. The real question is not if the Chinese economy will take a breather but rather if the landing will be hard or just soft.

Interestingly, the U.S. provided the best news for most of the month as the labor market showed signs of healing. However, there is a lot of work to be done and signs of dislocations remain.

We are going to take a closer look at Chinese stocks in the U.S. and in the world given the fact that Chinese economic news has such a profound impact on stock prices.


First of all, Shanghai is the center of gravity for Chinese stocks. The stock exchange had a volatile history in the past century. The Communists shut it down in 1949 and remained closed up until 1990 when on a chilly December day trading resumed. This gives the stock exchange a relatively short modern history of just 22 years. Yet this is where Chinese companies go for listings, over 2300 total compared to just less than two hundred in Hong Kong and the U.S. Market capitalization of the Shanghai Stock Exchange is $2.75 trillion, making it the fifth largest exchange in the world. Shanghai is not only large but is a very dynamic stock exchange measured testified by a large number of IPOs. Shanghai saw 279 Chinese companies going public in 2011, making it the largest IPO market in the world for the third time in a row. Shanghai was the place where Agricultural Bank of China (SHA:601288) raised over $22 billion, the most ever for any company in the world. Shanghai also hosted debut for Industrial and Commercial Bank of China (SHA:601398), the largest financial institution in the world, raising a then record $21.6 billion.

Hong Kong is the next largest market for Chinese stocks. The stock exchange itself is the third largest in Asia after Tokyo and Shanghai, where mainland Chinese stocks make up over 50% of the market cap for all of Hong Kong. This is remarkable, given that out of 1477 stocks only 177 are from the mainland. This suggests that large cap, mature, some of the best Chinese companies are listed in this “foreign” market for mainland Chinese companies.

In contrast to Hong Kong, Chinese stocks make up a mere 4.1% of the total market cap of U.S. exchanges. There are 188 Chinese listings on the NYSE and NASDAQ combined with a market cap of only $777.3 billion, just half of that in Hong Kong. This leaves a burning question mark in the minds of U.S. investors. Why do small Chinese companies choose the U.S. for listing?

Considering that 28 Chinese reverse merger stocks failed investors and got booted from the NASDAQ and the NYSE in 2011-2012 so far, the ultimate question is how legitimate are those remaining.

I am going to borrow a few slides from my presentation I held on this topic three weeks ago in Los Angeles at the Apple Investor Summit.


The first slide, IPO vs. Reverse Merger, compares the process of a reverse merger and the process of an IPO. The bottom line is that when a Chinese company gains U.S. listing via reverse merger, that’s a red flag right there. I’m not here to say that ALL reverse merger stocks are of low quality, but this is a central issue U.S. investors have to keep in mind. China XD Plastics (NASDAQ:CXDC) is a good example of a Chinese reverse merger company that is legitimate. The reason for my assessment is a $100 million investment from Morgan Stanley back in August 2011. High profile U.S. investment banks are very selective when it comes to Chinese stocks.

There are other important factors in consideration before making a stock recommendation. These are institutional ownership, trading volume, market capitalization, quality of the auditor and the investment advisor firm.

A Chinese company above $500 million in market cap can afford a big four auditor. But Chinese firms have been able to trick even big four auditors in the past, and as such that criteria alone is not sufficient to safeguard investments.

Investors better do some research into the investor relations firm that helped a reverse merger company to get listed. Some IR firms have a highly visible bad reputation and it is a factor U.S. investors must consider.

Based on all these factors Chinavestor identified a list of “safe” Chinese stocks on the NYSE and the NASDAQ. Investors have to consider that investing is not a crystal ball and as such there is no such thing as safe investment. It’s all relative but is still a useful term to separate darlings from the dogs.

The following three tables list these stocks sorted by market cap.The first one lists stocks from the NYSE.


The second one lists the cream of the crop from the NASDAQ. The third lists higher risk, higher return stocks from the NASDAQ.


From here on comes fundamentals. I continue to like (NASDAQ:BIDU), a company that delivers constant revenue and earnings growth.


Wish you successful investing, Blaze Fabry.

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