Goldman (GS) says China valuations attractive, offers sector and stock recommendations

You may be surprised by some of the recommended names. Here are the key points from the Goldman Sachs (ticker: GS) note:

• It is too early to sell Chinese equities as it expects the Morgan Stanley Capital International (MSCI) China index to offer a further 10-15% upside this year on the back of earnings revisions and a solid macro outlook.
• Positive earnings revisions should continue to support an upward trend in growth of the MSCI index which has registered gains of over 7% since mid-January this year.
• Improved macro data is also likely to strengthen market sentiment while undemanding valuations and favorable risk/reward profiles could limit the downside.
• Earnings forecasts of the MSCI index for FY 2005 and 2006 have been revised up by 2% and 3% respectively since the beginning of this year.
• The pick-up in the index's earnings momentum indicates anticipation of better corporate earnings.
• China's macro outlook has also continued to grow at a modest pace, led by robust consumer expectations, an increasing number of new projects, and strong foreign direct investment.
• The revision of 2005 GDP growth to 8% from 7% by the Chinese government indicates confidence in economic growth even though the new target is lower than the 9.5% growth achieved in 2004.
• Goldman believes growth could exceed 8% in 2005.
• Though a higher risk aversion has driven current valuations of Chinese equities lower than those of a year ago, Goldman believes these concerns are overdone as the market has not factored in favorable catalysts such as potential upward earnings and GDP revisions.

Chinese equity valuations are among the most attractive in the region:

• Low price multiples, high dividend yield, and high implied equity risk premium.

What sectors is Goldman recommending?

• In terms of sector allocation for the MSCI China index, Goldman favors energy and telecommunications.
• Goldman is less optimistic on financials.
• High oil prices are likely to remain.

Telecom predictions:

• Goldman upgraded the telecom sector to overweight from underweight because of potential industry restructuring.
• Fixed-line operators such as China Telecom (ticker: CHA) and China Netcom (ticker: CN) are favored over mobile carriers.
• Mobile operators like China Mobile (ticker: CHL) and China Unicom (ticker: CHU) could lose out in the case of consolidation of the industry.

China tax changes:

• Both the energy and telecom sectors will likely benefit if China lowers the enterprise income tax rate (EIT) to 25% in 2006 or 2007.
• Currently, domestic enterprises pay an EIT of about 33% while foreign-invested enterprises pay about 15%.

Companies to benefit from tax changes:

• PetroChina (ticker: PTR) and Sinopec 2006 earnings could increase as much as 12% as a result of EIT reform.
• Telecom earnings could increase 14-20%.

Financial stocks:

• A flattening yield curve will continue to dampen investment returns and share price performance in the financial sector, despite encouraging top-line growth.

Goldman's Top 10 picks (tickers for those traded in the United States):

• PetroChina (ticker: PTR)
• China Petroleum and Chemical (ticker: SNP)
• China Telecom (ticker: CHA)
• China Netcom (ticker: CN)
• Huaneng Power International (ticker: HNP)
• Aluminum Corporation of China (ticker: ACH)
• China Resources Enterprise
• Tencent Holdings
• China Pharmaceuticals Group
• Norstar Founders

Quick thought: What is most noteworthy about Goldman's recommendations? Many analysts have suggested that China's mobile operators will gain most from telecom industry consolidation this year. Goldman, on the other hand, believes fixed-line operators, China Telecom and China Netcom, have the most to gain.