China Shares Regain All Losses

Chinese stocks have risen since the notorious 9 percent intraday plunge in late February. As the matter of fact, the Shanghai Composite (^SSEC) is up almost 25 percent since the incident while the record breaking DJIA barely keeps space with such a sharp rally. Not surprisingly, Hong Kong is the laggard by delivering virtually zero growth. Please read our previous article, in which we argued that the Shanghai Composite Index is likely to outperform Hong Kong’s Hang Seng due to fundamental reasons.

And just to further demonstrate how strong the mainland’s exchanges became, consider the following developments.

"The Shanghai IPO of Bank of Communication s (3328.HK), China’s fifth largest lender, attracted a record $188 billion in subscriptions. Total subscriptions exceeded the previous all-time high for a domestic Chinese IPO, the $183 billion put up for last week’s Shanghai IPO of CITIC Bank So the ability of the markets to cope with two very large IPOs in quick succession, while stock indexes continued to climb to record highs this week, underlines the huge sums drawn to equity investment by China’s share market boom.” (April 26, Reuters, BoCom’s Shanghai IPO attracts record $188 billion).

The fact of the matter is that demand for stocks is strengthening as a rallying market, higher earnings and a robust economy draw investors. To highlight the magnitude of the market frenzy, consider the following numbers: more than 1.2 million new trading accounts were opened at China’s brokerages in the first four days in the last week of April, according to the latest figures published on the website of the China Securities Depository and Cleaning Corp. One, if not the biggest, draw for such an exuberance is that interest rates are low and individuals don’t have many alternatives to invest.

Given all circumstances, we keep our bullish outlook on the Chinese stocks, NYSE listings included, even though some argue that Chinese stocks became expensive. Bears like to highlight that the CSI 300 is valued at 40 times earnings, the most among 14 Asia-Pacific markets. India’s Sensitive Index is the second highest at 24 times. Still, a strong economy and optimistic 2007 company earnings will keep the good times rolling in Shanghai in our opinion. Besides fundamentals, there are artificial factors that lift the mainland’s exchanges. Chinese regulators will start to limit the number of mainland companies listing their shares in Hong Kong in a bid to encourage enterprises to join Chinese bourses.

According to the latest regulations, Beijing has introduced an unofficial policy allowing Chinese companies to list in Hong Kong only if the seek more than one billion US dollars or plan a simultaneous listing on the mainland. The idea is to force a large majority of listing candidates to become A-shares by joining the Shanghai or Shenzhen bourses bypassing Hong Kong. The increasing numbers of listed Ashare companies will help mop up excess liquidity and prevent a stock market bubble in China. In January, PwC predicted that Chinese companies would raise 25 billion US dollars via IPOs on mainland exchanges this year, up 50 percent. IPO proceeds raised in Hong Kong were expected to come in at 20 billion dollars, down 50 percent, in contrast.

Once would ask; why does it matter to me, U.S. based investor? Well, as we know home markets set the price of a stock and secondary market tend to mirror the price only. By home markets we mean stock markets with the most liquidity. It used to be Hong Kong for most of the NYSE listed Chinese equities however Shanghai started to overshadow Hong Kong’s role. And since only one third of the NYSE-HKEx stocks list in Shanghai, it is important to know which they are as most of the liquidity gravitates towards Shanghai these days. In other words, the Shanghai listed, NYSE cross-listed stocks are getting to be the most interesting ones as Shanghai is attracting most of the money flows.

As the following chart below shows, all Shanghai-NYSE listed stocks have recovered from the late February losses except the airliners, China Eastern Airlines (CEA) and China Southern Airlines (ZNH).

The weakness in the airliners sector should not come as a surprise given that the bulk of the operating costs is derived from kerosene. Since oil price keeps rising, investors tend to fled airliners. Also, Chinese airliners are extremely heavily debt burdened and as such are more prone to oil price fluctuations.

But going back to the strong Shanghai markets, we think big, liquid names will be on fire for at least this year. Just take a look at Aluminum Corporation of China (Chalco) (ACH) that debuted in Shanghai on April 30, Monday. Shares nearly tripled in the Shanghai debut, valuing it on par with world leader Alcoa Inc. The rise gave Chalco a market capitalization of 238 billion Yuan (US$30.9billion), just below the $31.3 billion market value of the world's largest aluminum producer, Alcoa (AA).

The first day gain also left Chalco's Shanghai-listed A shares at a 102 percent premium to its Hong Kong H shares, underlying concern that a bubble might be building in stocks as investors keep pouring in money. However some argue that with prices of Chinese metal stocks remaining relatively low compared to shares in red-hot sectors such as banks, Chalco's A share price is actually not that high. Chalco is trading at 18 times future earnings well below the giddy heights of the financial sector, where Industrial and Commercial Bank of China is trading at 32 times. Chalco, 8 percent owned by Alcoa, is the latest in a series of top Chinese companies to list on the domestic stock exchange over the past 10 months. The stock has been trading in Hong Kong and the NYSE for years so such an extraordinary debut came as a surprise. But this again, reinforces our assumption that Shanghai-NYSE cross-listed stocks are the way to go for now.

So let's see what stocks are in play then?

Chalco (ACH). From a technical point of view, shares of Chalco have risen 25 percent this year, beating a 0.98 percent loss in the index for Chinese companies listed in Hong Kong, as investors bet on China¡¦s rising demand for raw materials. However capacity builtup puts pressure on aluminum and alumina prices and as a result, the company expects to see net profits falling about 20 percent this year to 9.36 billion Yuan in 2007, according to 19 analysts polled by Reuters Estimates. Still, strong money flows will keep ACH prices from falling and we think this is a good company to invest now.

China Eastern Air (CEA). As we have reasoned in the past pages, we expect the company to remain in the red for the first six months of 2007. Jet fuel accounts for roughly 70 percent of Chinese carrier's operating costs. Besides high oil/kerosene prices, the company has a high debt ratio and fierce market competition. For these reasons we think it's better to stay away from CEA at this time.

Guangshen Rail (GSH). The company is mainly engaged in the railway passenger and freight transportation in the Pearl River Delta area between Guangzhou and Shenzhen. Shares of the company are up 55 percent since December 11, 2006—the time the company started to list A shares in Shanghai. Given current market momentum, GSH is a good company to own for short time investors.

Huaneng Power (HNP). The company develops, constructs, operates and manages large-scale power plants in China nationwide. For the first quarter of 2007, the company increased power output by 7.47 percent, which is below the national average. The unit fuel cost for power output of the company increased by 9.22 percent compared with the same period last year. The company faced relatively substantial operating pressure in terms of power output and fuel cost control. With increasing coal prices, profit will remain in the coal producers rather than power generators. For these reasons we think HNP is a hold right now.

China Life Insurance (LFC). Many still remember the fantastic 2006 run-up when shares of the company almost tripled. This run-up is mostly attributed to the exuberance caused by the foray of Shanghai listing. So far the stock prices fell in 2007 despite strong operating results. We expect LFC to regain momentum in the second half of the year.

Shanghai Petrochem. (SHI). A fuel producer and China's largest ethylene producer reported a first-quarter net profit of $138 million compared with a net loss of $20.8 million a year ago. The company expects to post a first-half net profit on lower crude oil costs and higher oil product prices in China. Sure, Beijing has a say on refined oil prices but we think the political risk is not as substantial this time.

Sinopec (SNP): Asia's largest refiner reported very strong Q4 results. Beat forecast by 54 percent in quarterly earnings, as easier crude prices and a one-off state compensation payout helped turn around its refining arm. With crude prices likely to hold steady this year, investors expect double-digit net profit for Sinpoec in 2007. But its fortunes hinge also on whether Beijing will allow it to charge more for refined products. Overall with a bright outlook, we think SNP is a good buy right now.

Yanzhou Coal (YZC): As we have argued, high coal prices drive the shares of the company. However operational bottlenecks prevent the company from reaching its potential. We think YZC will take a little breather before it will go higher in the second part of 2007.

China Southern Air (ZNH): fundamentally very similar to CEA, except the company is narrowly in the black. First quarter operating loss shrank, a good signal as we expect this company to outperform CEA in the coming quarters.

Comments

[john gaats]

Chinese EFTs such as FXI and PGJ are still lose on year to day basis. The stocks you mentioned are part of the indexes. So it is quite confusing that indexes losing while it components are regaining. Is this an arbitrage opportunity?