This incident highlights three important factors:
1. The integration of the Chinese stock market into the global flow of funds.
2. The volatility of the Chinese market compared to developed markets.
3. How to play China equities in the future.
The pure fact that the Chinese stock market could start a ripple effect with such a high magnitude is very remarkable. However it signals the beginning of a new era: China has become truly integrated into the global stock markets and, as such, is no longer a hedge against global downturns. Looking at the dramatic one day decline of the Shanghai Composite Index, it’s hard not to think of China as still an immature market. Putting this 9 percent drop into wider context though, investors have to consider two factors.
For one, the tumble came a day after the main index jumped to an all-time high, bringing gains for this year to 14 percent. The Shanghai Composite Index soared 130 percent last year, making it the world’s best performing major market. Secondly, there have been fears that authorities would crack down on the speculation that had driven shares to record highs. So from a psychological point of view, Alan Greenspan’s comments could not have come at a worse moment. Following the global downturn, Mr. Ben Bernanke swiftly intervened, saying “Taking all the new data into account, there is really no material change in our expectation for the U.S. economy since I last reported to Congress a couple of weeks ago.”
This message had the desired cooling effect on the DJIA. Furthermore China’s main stock index rebounded 4 percent on the following day and erased nearly half of the previous day’s losses as investors saw no fundamental reason for the turmoil. Having said that, let’s see how to play China, or Chinese stocks, in the future. One way to get some market intelligence is by looking at recent earnings announcements and the reaction to them. As the chart and table below show, Chinese stocks react very similarly to their U.S. counterparts.
Previous studies and trading experience taught us that stocks, opening with high gap following earnings announcements, lose momentum throughout the trading day. And adversely, stocks with relatively small gap at the open tend to offer trading opportunities during regular trading hours. Stocks that opened higher kept going higher until the close while stocks that opened lower continued to lose throughout the trading day.
There are two exceptions to this rule: China Techfaith Wireless Comm. Tech. Ltd (CNTF) and China Finance Online Co. (JRJC). Note however that these are the LEAST liquid stocks measured by market volume. If we were about to create a thumb rule for day-traders, this is what it would be: NASDAQ listed Chinese stocks with relatively small gap following an earnings announcement tend to offer trading opportunities. Stock prices tend to follow the direction of the gap, e.g. if the stock gapped up it will continue climbing or if the stock gapped down than it is most likely to keep going south for the rest of the day.
One important thing to consider; this rule is most likely to hold true with NASDAQ listings. Experience has taught us that NYSE stocks have different trading character ist ics, thus investors have to be cautious with them. Looking forward, four NASDAQ listings will report in the coming months: Home Inns & Hotels Management Inc. (HMIN), TOM Online (TOMO), Comtech Group (COGO) and eLong, Inc. (LONG).
Given HMIN’s short stock market history since it’s October IPO it’s hard to predict the impact of the first earnings announcement of this company. Another interesting stock to watch is TOM Online (TOMO). The stock has a good chance to benefit from the growth of the wireless internet services because of its leading position and balanced WVAS portfolio. Moreover, its joint venture with eBay Inc. has potential for another significant revenue source. Our previous analysis revealed that TOMO is trading at a relatively low valuation. Overall we think TOMO is a Buy at $11 or lower.
eLong Inc. (LONG), the Chinese online travel company is reporting on March 8. Given eLong’s long history of disappointing earnings, we don’t expect the company to shine this time either. The last public comment from the company was issued on November 9, 2006 when the company announced revenue guidance below analyst’s estimates. For this reason we are keeping our SELL rating on eLong Inc.
Looking at the NYSE names, March and April will be very exciting indeed. The petrochemical sector has four stocks to look at: Petrochina (PTR), CNOOC Ltd. (CEO), Sinopec and Sinopec Shanghai Petrochemical (SHI). As we argued last month, Petrochina is the safest bet. CNOOC Ltd. has delivered outstanding growth in 2006 that will be hard to surpass in 2007. The stock price has been under pressure in 2007 and lost almost 20 percent since then. Even if crude oil prices recover, CEO will it find hard to impress investors in the first two quarters of 2007. For this reason we think CEO is a HOLD.
Sinopec (SNP) has been the best performing oil stock in the past six months. We argued that the lower the crude price the higher the margin for refined oil for Sinopec. Given the rollercoaster ride of crude prices in 2007 so far, Sinopec performance is hard to predict. Sinopec is a HOLD in our opinion for now.
This is why we still think Petrochina (PTR) is the way to go for now. This integrated oil major is expected to keep growing along China’s overall growth and as long as its output targets are in line with expectations, we see no reason to exit. Our recommendation is to BUY.
Sinopec Shanghai Petrochemical (SHI) is a very tricky stock in deed. Since Beijing policy makers have the ultimate say on oil prices domestically, SHI has suffered huge losses with the rise in crude oil prices internationally. The government compensation from time to time make this stock very volatile and thus we recommend not to touch it for now.
Another large cap stock we follow closely is Aluminum Corp. of China, or Chalco (ACH). The stock has just recovered in the second half of 2006 to see it tumble in the last few days. While Chalco announced strong operational results in 2006 Q3, recent softening aluminum prices will put pressure on the stock. We argued in our last article that spot alumina prices are expected to rise, adding around 20 percent to Chalco’s bottom line. This assumption has proven right and the stock gained 10 percent. However rising production from China, notably Chalco, may result in the fall of spot aluminum prices as production is rising faster than demand. Considering the possible U.S. economic slowdown (Alan Greenspan’s comments) and Airbus’s just announced axing of 10,000 jobs, we think Chalco is a HOLD right now.
Looking at the Chinese telecom sector, investors have four companies to choose from: China Mobile (CHL), China Netcom (CN), China Telecom (CHA) and China Unicom (CHU). We have always preferred China Moblie (CHL) over the smaller cell phone carrier, China Unicom (CHU). Again, our previous article featured the phenomenal overall and monthly subscriber growth of CHL, the Chinese cell phone behemoth. Looking at its strong balance sheet and other financials, we maintain our long term BUY on CHL.
Another industry we keep a close eye on is energy. We argued in our last article that Yanzhou Coal (YZC) is an excellent choice for a number of reasons. The company is primarily engaged in underground mining, preparation and sale of coal, and railway transportation. It produces and sells thermal coal and semisoft coking coal to electric power plans, metallurgical mills, chemical engineering companies, and fuel trading companies. The company has proven and probable reserves of approximately 1968 million tons of coal in China. In addition, Yanzhou Coal offers rail transportation services and exports coal to various countries in East Asia, including Japan and Korea. Despite recent sell-off, the company is positioned to cash in on the 10 percent increase of coal prices for power plants in the coming months. In addition to strong fundamentals, we have seen considerable institutional share accumulation of Yanzhou Coal also.
And the stock has gained almost 15 percent just to see it all diminish after Mr. Greenspan’s remarks. Still, we see no fundamental change in Yanzhou’s operations or change in the coal mining industry in general. For this reason we maintain our BUY rating on Yanzhou Coal.
Another stock that will report in the coming month is Huaneng Power (HNP), the power generator. Huaneng is the largest independent power producer in China. This company is well positioned to benefit from China’s insatiable demand for power to drive its economic expansion. The company started to fuel its expansion through acquisitions (Huaneng bought a 25 percent stake in Shenzen Energy) while keeping its balance sheet healthy. We think Huaneng is another company to own for the long term and thus our recommendation is BUY.