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A Quality Chinese ADR is hard to find

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think_1 April, 2013 (Chinavestor) We have turned conservative since last November and have to admit that we did not foresee the winter and spring rallies that have propelled the Dow Jones Industrial Average (INDEXDJX:.DJI) and the S&P 500 to reach record highs in March 2013. There is nothing wrong with being conservative at a time when uncertainty is on the rise. We may have missed out on the latest upswing but that doesn’t alter our assessment of the current situation. We continue to believe that stock prices are reflecting an overly optimistic market sentiment and prices have to come back despite improving micro and macro economic news. Let’s just take a quick look at key indexes from China and the U.S.

The Dow Jones Industrial Average (INDEXDJX:.DJI) advanced 11.3% year-to-date (YTD), far outperforming its Chinese counterparts. The Hang Seng Index (INDEXHANGSENG:.HSI), an index that takes clues from the U.S., is down –1.6% in tandem with the Shanghai Composite Index (SHA:000001), an index that lost 1.4% YTD. The China ADR Index, a market cap weighted composite measuring the performance of Chinese ADRs listed on the NYSE and NASDAQ, is down 4.8% YTD.

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When risk appetite is on the rise, as evidenced by gold prices settling at 4 weeks lows today, one would question why Chinese stocks missed out on the rally. U.S. investors have to know why Chinese ADRs have been underperforming major U.S. indexes at a time when investors are taking on more risk. Historically, emerging market indexes have been outperforming the Dow when risk appetite was on the rise. But this year is different.

Taking a look at key equity indexes of other BRIC countries, China’s Shanghai Composite Index (SHA:000001) has been subpar compared to Brazil’s BOVESPA, India’s SENSEX and Russia’s MICEX. So Chinese equities have not only underperformed key U.S. indexes but also those of other BRIC countries.

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Investigating why China’s capital markets have been the weakest performers among BRIC counties would take us too far from our ultimate goal, e.g. advising investors about U.S. listed Chinese stocks, instead we will focus on key aspects of Chinese ADRs and their lack of performance.

First and foremost, we have seen an increasingly hostile geopolitical development where China is seen more as a foe than a friend. The mistrust is mutual.

Washington blames China for spying on its critical infrastructure over the internet, not to mention numerous attempts to steal classified military information. The U.S. has executed major military and naval exercises in the South China Sea and built alliances with the Philippines and other nations in the region to counter balance China’s rising power.

The Chinese have not been cooperating with the U.S. in issues like Syria and Iran, just to name a few, and more importantly for U.S. investors, on issues like corporate governance. We took note when the SEC’s offer to audit Chinese companies seeking U.S. listing in China by Chinese authorities, was turned down. Given that corporate governance has long been not considered vanguard in China, this lack of cooperation between the SEC and the Chinese Securities Commission deeply undermined trust in Chinese ADRs. And for a good reason!

We continue to see Chinese ADRs, once considered safe, exiting the NYSE and the NASDAQ. Some have been bought out or went private but unfortunately for many investors, most of them were kicked out and downgraded to trade on the OTC market.

Here is list of tickers from the last three to four months: CTDC, CTEL, CTFO, DEER, FSIN, GU, KH, VIT, YTEC.

Stocks with similar trading characteristics, e.g. lack of volume and penny stock price, include CMFO, CXDC, GSI, TRIT, just to name a few.

The exodus of Chinese listings from U.S. equity markets is to continue due to lack of trust resulting from a shady corporate accounting by the Chinese.

And there is a contagion effect taking place that I have noticed. Lack of investor confidence for Chinese stocks are now hurting quality companies, such as China Eastern Airlines (NYSE:CEA). This particular airline is the second largest by fleet size in China and controls the skies above Shanghai, the financial capital of the country. This would make it an interesting stock for many, yet trading volume has dried up to a mere few thousand shares a day on average in New York! The same company attracts 5.4 million share turnover in Hong Kong (HKG:0670) and close to 20 million trading volume in Shanghai (SHA:600115).

This is a relatively new development that I just illustrated using China Eastern Airlines (NYSE:CEA). But this phenomena, e.g. lack of investor confidence, is largely to blame for the subpar performance of Chinese stocks in the U.S. Given that there is no change in sight in enforcing Chinese listings to improve their accounting standard, I don’t see much price improvement coming for Chinese ADRs in the near future.

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We have to come to the same conclusion by looking at the performance of Chinese ADRs in March. Health care and consumer non-cyclical stocks outperformed the broad market while financial and capital goods suffered as evidenced by the chart on this page. What’s troublesome is that market cap of each and every health care stock except for Mindray Medical (NYSE:MR) is under $500 million. None of them can afford a top four auditor and even that has not proved to be bullet proof in the last few years. So how can someone have a reasonable level of confidence investing in stock like 3SBio Inc. (NASDAQ:SSRX) or Simcere Pharma (NYSE:SCR) or WuXi Pharma (NYSE:WX) when they don’t have a quality auditor and lack trading volume?

And the same is true for consumer durables with stocks like China Marine Food (NASDAQ:CMFO) or Origin Agritech (NASDAQ:SEED). Even Zhongpin Inc. (NASDAQ:HOGS), the largest company within the sector, has a market cap of under $500 million.

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This line of thought takes us to examine another group of Chinese stocks, the solar sector. Once mighty Suntech Power (NYSE:STP), the largest integrated solar panel manufacturer in the world, filed for bankruptcy on March 20, 2013. Market cap of this and other leading PV manufacturers once topped $5 billion but has crumbled as losses mounted and cheap financing dried up. The whole solar sector is highly leveraged and has little room left to maneuver thanks to excess capacity and low prices. And as the chart on this page testifies, it’s not just Suntech Power (NYSE:STP) that’s suffering but virtually each and every Chinese solar maker lost 90% of its market cap over the last ten years.

The sector has seen a similar free fall back in 2008 and selected companies like Train Solar (NYSE:TSL) and Jinko Solar (NYSE:JKS) have recovered in the subsequent three years. There are always optimists out there. But prudent investors have to think twice before putting a bet on a Chinese ADR these days.

We continue to prefer stocks that are industry leaders, have strong cash positions and operating results. For details, visit our conservative and growth portfolios.

Wish you successful investing, Blaze Fabry.



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