2006: The Year For Chinese Stocks

2006 was “The Year” for Chinese stocks. A seemingly unquenchable investor thirst for all things Chinese helped propel the Shanghai Composite Index to a 130% gain for the year, followed closely by the Hang Seng China Enterprise Index [HSCE].

Although Shanghai’s stellar performance in 2006 is somewhat misleading because compilers of the Shanghai Composite Index include IPOs right from their debut day, giving the mainland index a regular and artificial boost, the triple digit gain is still remarkable. The interest in China spurred Hong Kong‘s Hang Seng Index to a 34% gain in 2006. The China Enterprise Index, which comprises major Chinese companies, or H-shares, such as PetroChina (PTR) or China Life Insurance (LFC), nearly doubled in value.

Thanks to the composition of the Xinhua China 25 Index (FXI), which basically has the same components as the China Enterprise Index, U.S. investors could capture the stellar performance of the Chinese stock universe. FXI nearly doubled its value, far outperforming the Halter USX China Index (PGJ), not to mention the Dow.

What do we expect in 2007? Will this trend continue? If so, how to get the best out of it?First of all, investors have to realize that most of the spectacular index gains are attributed to large cap stocks. We expect to see their strong momentum to carry well into 2007. These large cap stocks make up the Hang Seng China Enterprise and the Xinhua China 25 Indexes composition and as a result, we think these will do well in 2007. As we have previously argued, the Shanghai Composite is biased and artificially boosted the way IPOs are calculated into the index performance. With a strong IPO pipeline, Shanghai is expected to perform well in 2007 though not as spectacular as in 2006. Mega IPOs like ICBC’s $20 billion plus are unlikely to occur as the banking sector went public by 2006. If history can predict future, PGJ will most likely underperform its ETF peer, FXI. We have always preferred FXI and have been vocal about it. Still, PGJ is expected to cheer investors alongside China’s overall economic growth.

In addition, we expect the Hang Seng to beat the DJIA in 2007 again. The Hang Seng Index is fueled by a 29% annualized increase in industrial profits, not to mention China’s economic expansion of over 10 percent in 2006. This marks the fourth straight double-digit annual gain.

Looking at these indexes from a historical perspective, the following chart is worth a million words.

The green line represents the China Enterprise Index known as H-shares [HSCE], the orange stands for the Hang Seng [HSI], the red for the DJIA [DJI] and the blue for the Shanghai Composite [SHCOMP]. The chart reveals that the H-share Index far outperformed any other major benchmark over the last five years. In addition, Shanghai’s 130% gain in 2006 helped it to surpass the DJIA and close in on the Hang Seng yet it is just in sync with the overall performance of those major indexes.

This chart suggests that gains of the Hang Seng and Shanghai Indexes are attributed mainly to companies making up for the H-share Index. Who are these mysterious H-shares? Most foreign investors interested in China’s companies prefer to trade H-shares, or mainland companies that list in Hong Kong, Shanghai and New York, and comply with international accounting and governance rules. Companies from the H-share index that are listed both in Hong Kong and New York and thus are readily available for U.S. investors are:

Aluminum Corp. of China (ACH) [2600.HK]

China Life Insurance (LFC) [2628.HK]

Guangshen Rail (GSH) [0525.HK]

Huaneng Power (HNP) [0902.HK]

PetroChina (PTR) [0857]

Shanghai Petrochemical (SHI) [0338.HK]

Sinopec Corp. (SNP) [0386.HK]

Yanzhou Coal (YZC) [1171.HK]

The rest of the stocks, making up the H-share Index, are not listed in New York but include blue-chips like Bank of Communications [3328.HK], Bank of China [3988.HK], Datang Power [0991.HK] and China Shenhua [1088.HK] - just to name a few.

Still, investors can capture basically the same growth of the China Enterprise Index or H-shares and play the Chinese craze by investing in the ETF tracking the Xinhua China 25 Index: the FXI. As the following chart shows, there is extremely strong correlation between the performance of the H-share index [HSCE] and the FXI.

The chart tracks the FXI since its inception on 10/14/2004 along the H-share index.Top ten stocks of FXI holdings are:

China Franklin Mobile (CHL) 10.98%

PetroChina Co (PTR) 8.81%

Bank of China Ltd 7.41%

China Life Ins. (LFC) 7.33%

CNOOC Ltd (CEO) 6.15%

BOC Hong Kong (BHKLY) 4.22%

Sinopec (SNP) 4.18%

Citic Pacific Ltd (CTPCY) 4.15%

Ping An Ins. 4.05%

China Telecom (CHA) 4.01%

The advantage of FXI over individual stocks is that since FXI represents 25 underlying stocks, it carries minimal company specific risk.

Still, if investors want to pick individual stocks, this is what we think. Large cap stocks will carry over momentum from 2006 and will continue to do well in 2007. Looking at the stellar performance of China Life Insurance (LFC), it is unlikely that the company will almost triple its value in 2007 as it did in 2006, but a high double digit gain is very plausible. Large
cap telecom stocks are expected to outperform in 2007 as well, just as we have seen them excel from the beginning of the second half of 2006. China Mobile (CHL), China Unicom (CHU), Hutchinson Telecom (HTX) and China Netcom (CN) are poised to capture the telecom frenzy.

The spectacular gains from the oil industry—SNP, PTR, and CEO gained 92.2%, 79.2 and 44.1%, respectively in 2006—are unlikely to repeat. Earnings of these companies are subject to international oil prices and we don’t expect the crude oil run-up of 2006 being surpassed in 2007.

Looking back to 2006, one of the lessons Chinese stock investors learned is that you don’t have to take high risk to achieve stellar returns. Small cap NASDAQ listed names, the most risky of the U.S. listed Chinese stock universe, are dominant among the worst stocks of 2006. Eye-catchy, fancy names or sound business models alone were not enough to support stock prices anymore. The erosion of eLong Inc. (LONG) from rival Crip.com (CTRP) is clearly the result of delivering results versus showing potential. The weak performance of the wireless value added services sector indicate that the “blink-blink” is over.

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