A50 Tracker and HS China Enterprises Index (HKCEI) Technical Analysis

Just want to share the following two set of charts, seems like no charting tool can concurrently display two MACD, I've manually paste the A50 (using 2823.hk as proxy) and HSCEI MACD side by side to better analyze the two recent opposite trends.

In hindsight, should have been alerted in early August when HKCEI MACD was developing a stronger and stronger negative divergence.

Currently A50 is also developing a negative MACD divergence, will it develop further and it's a sign of A-share market correction?

I’ve no crystal ball but I am a bit cautious about the recent policy risk developing in China based on what I observed and heard:

• No action has been taken yet on the 5.6% July CPI figure which was announced last Monday
• Rumours of new housing loan policy with down payment increased to 50% and no new loan for 2nd home

For anyone interested in treasure hunt HK stocks, especially those new IPO listed since 2006, here is an analysis of all Hong Kong IPO performance for 2006 and 2007.

Impact of A Share H Share and Red Chip Convergence to 3 ETF (CAF, FXI, A-50 Tracker)

"There's no reason why stocks listed in Shanghai cannot through some financial instruments be traded in Hong Kong. Similarly, I do not see why Hong Kong stocks cannot be co-listed in the Shanghai stock market through an arbitrage arrangement. We are discussing the mechanics of it."

Hong Kong SAR Chief Executive Mr. Donald Tsang said in an interview with Financial Times on 18 June.

Mr. Tsang is a very smart politician and he is especially good in gaining trusts from his bosses in Beijing, that’s why he could replace Mr. Tung Chee Hua, the past HKSAR Chief Executive in the middle of Mr. Tung’s tenure.

Mr. Tsang has also been very cautious in delivering messages from Beijing, he would not disclose any plan on change of Chinese policy unless it is 100% confirmed.

As such I would expect new policy leading to price convergence of dual listed shares in Hong Kong and China would be announced very soon.

The convergence has in fact already been started, we see a very strong upward momentum of Hong Kong listed Chinese companies since the Chinese market correction earlier this month. See the chart below comparing SH Composite with HSCEI (Hang Seng China Enterprises Index):

A Shares in Shanghai or Shenzhen are trading at premium to their H share counterparts listd in Hong Kong. As of 22 June H shares are discounted by 1.5% to 88%.

If you are holding any funds or ETF with A, H or Red Chip as underlying assets, you shall evaluate such convergence impact immediately.

Three such most common ETFs traded in US and HK are :

1. Morgan Stanley China A-Share Fund (CAF)
2. iShares FTSE/Xinhua China 25 Index (FXI)
3. iShares FTSE/Xinhua A50 China Tracker (2823.HK)

Following is my analysis of the potential impact to these 3 ETFs:

As the actual market reaction is impossible to predict, I’ve made the following assumptions in my analysis:

• Only constituents of each fund which are dual listed in HK and China are considered
• Uniform convergence of each dual listed stock
• The price gap between H and A share would not be completed closed, for illustration purpose I assumed H shares to go up by 70% (of the gap) and A shares to go down by 30%.
• Correlation of H share and Red Chip movement is ignored.
• Impact to "A only” shares (i.e., not dual listed as “A” and “H”) is ignored.
• Similarly impact to Red Chips is ignored.

In this TABLE I listed the H share discount for all 44 dual listed Chinese shares, composition break down for each of CAF, A-50 and FXI, and multiplied the discount and composition % to arrive at the potential impact. You can study the impact down to each stock in the table if you are interested.

In summary:

FXI has 39.55% of NAV invested in 10 H-Share companies (out of the 44 dual listed) giving a positive upside potential of 7.7%

CAF has 22.25% of NAV invested in 7 A-Share companies (out of the 44 dual listed) giving a potential downside of 1.8%

A-50 Tracker has 30.3% of NAV invested in 20 Chinese A-Shares Access Product (out of the 44 dual listed) giving a potential downside of 2.2%

Several Very Important Remarks :

1. My assumption of uniform price correction to all dual listed stocks is for simplicity only. I expect high quality H shares would experience a stronger re-valuation. So buying those shares with heaviest H discounts would not guarantee you profits.
2. As Red Chips will be returning home to list as A share in China too, we can anticipate similar re-valuation of those Red Chips, which is beneficial to FXI (or other funds or indices with strong Red Chip exposure) as it holds several high quality Red Chips such as China Mobile and CITIC Pacific.

What is my investment strategy to profit from this trend?

I have bought HSCEI index products, on top I have overweighed several selected H shares and Red chips as potential profit enhancers. How to pick those star companies? Let's discuss together in my Discussion Group !

Chinese RMB Yield Curve

The yield curve adjustment in US market was the biggest event last week and the effect has rippled through to other part of the world. While China is a red hot subject nowadays, how come nobody talks about the Chinese RMB yield curve? Do you have any idea as simple as the shape of the curve?

You probably are not interested because RMB is not a freely traded currency, and you are not allowed to buy RMB bonds.

But are you investing in Chinese H-share or A-share based ETF such as Morgan Stanley A-Share Fund (CAF), iShares FTSE/Xinhua China 25 Index (FXI) or iShares FTSE/Xinhua A50 China Tracker (2823.HK) ?

Do you know all those funds are having a significant proportion of their assets invested in Chinese banks and insurance companies?

For example, the following list shows the 25 constituents of FXI, almost 40% of its assets are in Chinese banks and insurance companies



So how does this relate to the RMB yield curve?

If you are indirectly owning so much Chinese banks assets, you may be interested to know how do Chinese financial institutions manage credit risk, how do they perform mark-to-market financial assets valuations, how do they report VaR (Value-at-Risk) or CAR (Capital Adequacy Ratio) which are critical measurements of banks’ health.

In other part of the word, yield curve is the most fundamental element to derive discount rates for cash flow projection, which itself is the basis for any financial assets valuations.

However, you may be very surprised to learn that this seems to be obvious matter is a brand new policy just imposed last week ! On 15 June CBRC made an announcement that banks should make reference to RMB yield curves in financial assets valuation and reporting starting from Oct 2007. Before this is enforced Chinese banks are not referencing to RMB yield curve and they derive their own discount rates based on arbitrary and subjective measures. So there is in fact not a common point of reference when we interpret reports from different Chinese banks. Is the credit management of one bank better than the other as indicated from its annual report? I am not too sure.

It is still a very long road to a mature capital market in China. What we have seen in the A-share market is just a beginning of the overall Chinese capital market reform. Without a solid equity market foundation it would be difficult to move forward to develop a corporate debt market. RMB yield curves are in fact incomplete because secondary market for corporate bonds is inactive. Without a well developed debt market the Chinese goverment would find it difficult to solve banks’ non performing loan problems because there is not a vehicle for a more balanced distribution of risks to different classes of investors. Bank loans are currently the major source of funding for all Chinese firms. Based on PBOC statistics, in 2006 Chinese firms raised a total of RMB 4000b, of which RMB 3300b (82%) were bank loans, only 5.6% (RMB 230b) was from equity market.

My View

1. China is speeding up in debt market development which is crucial to the overall health of Chinese economy
2. A healthy stock market is the fundamental requirement for debt market development, I cannot believe the Chinese government will do any stupid things to destroy what they have painfully developed over the past few years. Tackling the astronomical sum of non performing bank loans and ultimately listing all banks were huge achievements. Though the system is far from perfect, it is a one way road, the Chinese market can only be healthier.

Finally, here is the RMB yield curve in case you are interested.

Filtering market noise in China

The inconsistent message from the Ministry of Finance about stock transaction duty tax hike caught the market by surprise and caused an almost 21% correction from its peak of 4335 on 29 May to its lowest of 3406 on 5 June to the Chinese Shanghai Composite index.

Though I’ve profited from my H-share and A-share index call warrants which I bought on 7 June, what interested me more is to see what lesson I can learn from the incident.

A recap of the chain of events:

22 May:

Market rumoured that transaction duty would be raised from 1% to 3%

23 May:

“Responsible representatives” (the exact wordings in Chinese are “有关部门负责人”) from Ministry of Finance and The State Administration of Taxation (国税总局) confirmed with a reporter of Shanghai Stock News (上海证券报) that they have not heard of such policy change. After such story was published by Shanghai Stock News, it was widely quoted by other online and print media in both China and Hong Kong.

29 May:

Ministry of Finance announced the 1% to 3% increase of transaction duty

I tried to dig out speific names of the spokespersons on 23 May. I’ve searched Baidu (the most popular search engine in China) and Xinhuanet which is the official China News Agency web site, my effort was in vain.

Anyway, I believe the comment from the unidentified persons were unintentional. Most likely the reporter from Shanghai Stock News was unable to approach related senior officials for comment and so he/she just picked anyone reachable. Unfortunately in this incident the individuals who provided comments might not have enough knowledge of what the real government plan was.

Catch you by surprise (出其不意)

This 29/5 incident reminded me of another one happened in July 2005 when China announced its currency policy reform with RMB referenced to a basket of currency instead of US dollar alone.

For that incident, Premier Wen Jiabao has in fact pre-announced his plan when he told the world his intention. Back on 14^th March 2005 Premier Wen has told the media that China was planning on a significant currency reform and he further added that “it might catch you by surprise” (出其不意) when being asked about the timing.

What were the differences between these two incidents?

• One comment was made by an anonymous person while the other was made by a highly respected Chinese leader.
• One was to cool down (not to kill) the local stock market while the other was to avoid foreign speculators to take advantage of the RMB appreciation.
  

So what have I learned?

1. I will take comments from unidentified sources with a grain of salt.
2. Any significant correction caused by rumours in China is good buying opportunity (the Feb correction was also caused by rumours of same nature). Refer to the chart below to see how quickly the two corrections were fully recovered. I maintained my long term bullish view on China.
   

1. 

3. A-50 tracker ETF (2823.HK) is the best instrument I can access having the highest correlation to Shanghai index. I was using CAF as a proxy but it proved to be a failure. CAF is still having 20.9% discount to NAV while A-50 Tracker (2823.HK) has almost completely closed the gap with only 2.6% discount as of today’s closing. Why CAF is lagging? Apart from supply/demand dynamics the performance of its underlying against index is other contributor.
   

Who Moved The Chinese Market?

Shanghai closed today at 3890.8, up 3.03%. It is also the first time that there are more advances then declines (894 vs. 378) since the announcement of the tripled duty tax on 29 May.



Over the last 7 trading days, Shanghai Composite has corrected by 21% from its peak of 4335 on 29 May to its lowest of 3406 on 5 June, and still by 10% as of today.


This size of correction is totally unexpected by the government, over the last 2 days there were various government officials trying to comfort the over-reacted crowds with bullish comments in different media.

In addition, 4 new equity oriented mutual funds are approved and will be launched next week. Last time when a large number of funds were concurrently approved was on 6 Feb, when the market collapsed by 10% from 30 Jan to 5 Feb.

Obviously the government is trying to fix the aftermath.

So what was the cause for this latest correction? It was not the tripled duty tax, as I mentioned in my last article the practical impact of it is insignificant.

The real cause was the poorly managed and inconsistent message from the government. Just a few days before the 29 May announcement was made by the Ministry of Finance, the media had confirmed with another spokesperson of MoF that there was no such plan.

It is exactly this inconsistency which caused the market panic, as investors have no clue which message could they trust in future.

I think such inconsistency was unintentional, I believe Chinese authorities would learn from this incident and be more careful when government officials talk to media.

Another by-product of this correction is a tightening of the A-share/H-share price gap from the previous 30%+ premium exhibited by A-share. As can be seen from the chart below the Hang Seng China Enterprises Index (which tracks H-share in Hong Kong) has in fact gone up while the A-share index was free falling in the period.




This is the first time inexperienced Chinese investors (17% of the total trading accounts in China were freshly opened in past 4 months) got their fingers burned, at least for a period of time that 17% of the retail investors would remember this incident.

I believe Chinese investors would also start looking at other less risky investment vehicles which they are familiar with, such as QDII (Qualified Domestic Institutional Investor) funds the government recently relaxed. (Up to 50% of a QDII approved fund can be invested in equities from 0% in the past). As Hong Kong is the only authorized market QDII funds can put their money, most of such funds would likely allocate their equity portion to Hong Kong listed H-shares, red chips and Hong Kong blue chips which are all familiar names to Chinese investors, that would be a catalyst to H-share index though the absolute amount is still small comparing to the HK market cap.

Besides, there are more mainland Chinese investors using a grey channel to invest directly in Hong Kong stocks without going through QDII. Though RMB is not a freely traded currency, Chinese citizen is allowed to buy up to US$50K per year for their spending when they travel to Hong Kong. For a family with 3 members it’s already US$150K which is not a small number at all from Chinese standard. Though officially it is not allowed, still some of them would open a HK stock trading account when they travel to HK and place orders over internet or phone. In fact a local Hong Kong broker said today around 50% of its orders are coming from mainland customers. I would not under-estimate this effect which would even be more significant than the QDII channel.

I’ve also adjusted my trading strategy and would allocate part of my portfolio to H-share index ETF (2828.HK) rather than purely on A-share related ETFs (CAF and A-50 Tracker). Now I am equally bullish on both A-share and H-share.


Disclosure: I have LONG positions in H-share index call warrant and A-50 index call warrant

Reading between the lines: China's tripled stamp duty

[31 May 2007: Corrected version]

Mr. Xiang Huaicheng, former Minister of Finance and current Chairman of the National Council for Social Security Fund recently commented on the stock market craze with a “beer bubble” analogy, saying beer would not be as tasty without bubble. Market well received his message as an indication that the government would not impose drastic measures to cool down the market.

To most people’s surprise Ministry of Finance made an announcement very late last night that the stamp duty would be trebled. So is Chairman Xiang’s message inconsistent with that the action from Ministry of Finance?

To interpret that let’s first look at the related entities under the Chinese government structure:



MoF, CSRC, CBRC, Social Security Fund and PBoC are entities all directly reporting to the State Council, that is to say heads of those entities are at same rank within the government structure and each entity is supposed to have its own authority to impose new policy within its scope of responsibility, that explained the action of MoF last night.

Having said that, as action from each entity would also have significant impacts to China’s economic well being, I would tend to believe they would work very closely while independently and communicate with each other before any new policy or significant change in policy is announced to public. So I suspect Chairman Xiang was well aware of MoF’s action beforehand though he might not know the exact announcement date, he didn’t see that as drastic measure at all and that’s why he talked about his ‘beer bubble’ theory just one week before MoF’s action.

Let’s also look at the timing of last night's MoF announcement. It was announced at almost midnight on a Tuesday while most announcements of this type were made on Friday after market or right before or during a long holiday so that public can have time to digest such announcement to avoid irrational impulsive market behaviour. On the contrary, this time MoF deliberately made the announcement at such an unconventional timing in order to encourage impulsive market reaction. That was very effective and caused the market to drop by 6% in both Shanghai and Shenzhen. I would say such market behaviour was irrational because what impact in absolute sense is the 0.2% tax increase when the market has been going up at a rate several order of magnitude faster than that?

MoF’s objective is to cause a sudden abrupt change in market direction in order to give a more remarkable signal to the market participants that the government can and will do something if necessary. However, as the real impact is minimal, I foresee the market will totally recover in no more than a few days.

The ‘beer bubble’ analogy from Chairman Xiang and MoF’s deliberate choice of timing together made me believe the government really would not want to cause the market to correct drastically while occasional correction of 10% or so would be expected.

I take this as a good buy opportunity and I've bought some CAF while writing this article. The discount gap of ~20% between CAF vs. A-50 tracker (2823.HK) is too attractive to miss.


Disclosure: I have a long position in CAF

A Review of My Previous Prediction on Chinese Banks Performance

On 6 Feb 2007 I’ve written an article “Chinese Banks: A Non-Traditional Approach to Predicting Their Performance” in which I described how I rate 3 Chinese banks' future performance based on their historical non performing loan (NPL) problems and my argument is simply “bad habit dies hard” especially in China where management appointment is more based on relationship (though it's changing).

At that moment while all analysts were promoting ICBC (saying ICBC is the largest bank in China, ecomomies of scales, with the most advanced IT system, etc) and BOC (saying BOC is the only Chinese bank with international presence), I analyzed them using a totally non-traditional approach and rated China Construction Bank (939.HK) as the best performer versus ICBC (1398.HK) and Bank of China (3988.HK)

Today I’ve revisited their relative performance both from the date of my article and also their recovery capability after the Feb market correction.

The following charts will speak for themselves

From the date of my article on 6 Feb (click for a clearer image)


From the early March market correction (click for a clearer image)


In my last article I said:

“..We also noticed that CCB was also the first state owned bank listed overseas. This is by no means a coincident. The Chinese leaders have to ensure the success of the first listed so as to set a stage for the others, as such it is reasonable to assume that the leaders should have selected the best bank to be the pioneer. Who else would have better insider information than the Chinese leaders? It would be your decision to bet with the Chinese leaders' choice or analysts' DCF models…”

In general I do not believe in DCF models, I think even the CEOs CFOs themselves are unable to tell you what are their firms' grow rates for initial years/terminal growth rates, nor could anyone predict the interest rates for next 10 years (or whatever horizon in the model), while DCF analysis is very sensitive to those assumptions how valuable is this time-value based modelling of a firm's fair price? I would rather use P/E comparables if I want to have a gut feel of a firm's value.

In my analysis of the Chinese banks, my approach is totally unscientific. While it's a common belief that historical data cannot predict future performance, that may not be completely true for China and I would continue to give my vote of confidence to our great Chinese leaders than forecasts based on DCF models!

Here is my previous story again in case you are interested.


Disclosure: I own CCB (0939.HK) at the time of writing this article.

Chinese Castle In The Air – China A-Share Market Craze

Famous economist John Maynard Keynes applied psychological principles to investment theory and pronounced the “Castle in the air” theory back in 1936.

It analyzes how the crowd of investors will behave in future, stock valuation is based on optimism and investors tend to build their hopes into castles in the air. That applied to the dotcom craze, it also applies to the current China A-share market.

This week is the “Golden Week” in China, this national holiday lasts for a week and local stock markets are closed. Most Chinese will take a break from watching stock quotation screens and travel to Hong Kong or overseas for vacation trips.

A relative of mine from Guangzhou visited me yesterday in Hong Kong and I took the chance trying to understand first hand the development of the A-share craze. She is a 60 years old house wife, a retired civil servant, never invested in stock market until very recently.

Here are some interesting points:

• People only talk about stocks no matter in restaurants, universities or work place, you can hardly set up business meetings with anyone before 3PM which is the stock market closing time.
  

• They are rushing to open stock trading accounts, though the initial account opening deposit requirement has been increased 10 times from RMB5,000 to RMB50,000. (RMB50,000 is almost the annual salary for an average person in Guangzhou.)
  

• Chinese investors are speculating not only on stocks, but also mutual funds. Most investors think mutual funds are sure win investment because they are managed by ‘professional managers’

Interestingly, my relative knows she is gambling. She said she couldn’t understand why some stocks can keep going up even though they are money losing companies, she kept telling me the market will collapse sooner or later. This can perfectly be explained by the “Castle in the air” theory, everybody is looking for the next bigger fool.

The Chinese castle is developed because of one single reason, foreign investors are prohibited from A-share investment in general except those with QFII (Qualified Foreign Institutional Investor) quota allocation which itself is a scarce resource. Total QFII allocation is less than 1% of the total Chinese market capitalization and hence impact from international institutional investors are negligible.

In fact international investors are becoming more cautious of the A-share craze, one very good indication is the discount/premium demonstrated by the Morgan Stanley China A-share Fund (CAF).

From the chart below we can clearly see that CAF has reverted from its all time high of 15% premium in Dec 2006 into its current discount of 15% and the discount level is still keep increasing. Similar pattern can also be observed from the iShares FTSE/Xinhua A50 China Tracker (IFXAF.PK or 2823.HK).

This is opposed to the uni-directional movement of the Shanghai Index:

It’s hard to tell when will the A-share market correct, but I would say it has to be triggered by Chinese Government’s administrative intervention because all external forces will have no effect in this closed investment environment.

I am unwilling to bet on such timing and I have exited all my positions in CAF.

Disclosure: I have no position in the above mentioned stocks.

A Big Event For Chinese Stock Market in 2007

The Chinese market correction is not due to the unwinding of carry trades by international hedge funds. Chinese currency is not free floated, apart from that, only foreign investors with QFII quotas are allowed to trade Chinese A-share subject to stringent lock up conditions. So the sudden change in direction must have been solely caused by local Chinese investors and local Chinese funds.

Two very significant meetings, the so called "two sessions" -- the annual meetings of China's top legislature and political advisory body are concurrently held in Beijing over these two weeks:

i) the Fifth Session of the Tenth National People's Congress (NPC), the meeting in which new policy and legislation in China will be discussed and enacted and

ii) The Chinese People's Political Consultative Conference (CPPCC), a meeting participated by appointed representatives from all walks of life in which major policy decisions are consulted.

Before the meetings were started this Monday there have been rumours related to new government policy to cool down the stock market. Though nobody can show the exact reasons for the sudden and abrupt market correction, the fear created by the rumours is the most likely cause. Now three days has passed and no such agenda is tabled to discuss the heat of the market, investors' anxiety is relieved and the market starts to pick up again.

There is one very important message I picked up from the news this week, it’s about China’s plan to list those Hong Kong listed ‘Red Chips’ back to Shanghai market as A-share.

Before I go on, we must understand clearly what those jargons are:

Red Chips

Hong Kong registered company listed in the Hong Kong Stock Exchange with at least 30 per cent of its shares in aggregate held directly by Mainland China entities with the Mainland China entities being the single largest shareholders in aggregate terms. In plain English it is basically a shell listing in Hong Kong with assets injection from a Chinese company. Shares are denominated in Hong Kong dollar which is pegged to US dollar and is freely traded. Both Hong Kong citizen and overseas investors are allowed to trade.

A Shares

China registered companies listed in either the Shanghai Stock Exchange or the Shenzhen Stock exchange, shares are denominated in Yuan which is not a freely traded currency. Only Chinese citizens or foreign investors with QFII quota are allowed to trade.

According to a speech last week by the Chairman of Shanghai Stock Exchange Mr. Geng Liang, the Red Chips will return home as early as June this year. What’s the significance of this news?

By the end of November, there are 85 red chip companies listed in Hong Kong with a total market cap of HK$2000B, while the market cap of all Shanghai Stock Exchange listed companies is around RMB7160M (or HK$7300B). That is, over 20% of Chinese assets are listed in Hong Kong as Red Chips.

Under the current mainland China regulations, overseas incorporated companies are not allowed to be listed as A-share in mainland (companies must be registered in mainland for over 3 years and with at least 3 year’s profit records). However, as Red Chips are in fact mainland companies back door listed in Hong Kong, amending the rules will not be a too difficult task for the China Securities Regulatory Commission, the SEC equivalent in China.

Such return is seen as another step taken by the mainland to strengthen the Chinese stock market. As most of the Red Chips are large caps with long operating history under Hong Kong's listing regulation which is more stringent than the mainland rules in terms of disclosure requirements, their returns mean an increased supply of high quality stocks to the Chinese investment community. Lack of high quality stock is a reason why China Life A-share is trading at 62% premium over its H-share while the shareholder rights are exactly the same. Following table will give you some more illustrations of the A-share premium.

So who are those Red Chips in the queue to return home? Out of the 85 companies it is widely speculated that the followings will be among the pioneers:

• China Mobile (CHL, 0941.HK)
• China Telecom (CHA, 0728.HK)
• China Netcom (CN, 0906.HK)
• CNOOC (CEO, 0833.HK)

For those telecom stocks, the priority is obvious. They have immediate funding needs to prepare for the 3G capex when such license is granted, it makes sense to raise new fund in local currency which will be spent locally.

From investor perspective this will also be good news, we expect to see a healthier mainland stock market with less volatility while still giving us a very promising expected return. This is a very important first step to manage the heat of the market, another step expected to happen this year is the creation of a channel to allow arbitrage between H-share and A-share (eg, via CDR Chinese Depository Receipt) to tighten the spread between the markets. I will write more about this second step when it is closer to reality.

How can investors benefit from China’s 1-child policy?

When Maslow's hierarchy of needs is applied to the increasing GDP per capita in China, it becomes obvious that stocks related to human being’s basic needs will be good investment candidates.

In fact this investment opportunity has existed as early as June 1993 when the first H share company was listed in Hong Kong, and that company was Tsingtao Beer (HK: 0168, TSGTY). Even for non-Chinese this name shall not be too unfamiliar to you as Tsingtao is available in some 95% of Chinese restaurants in the US and it was first introduced into US in 1972. How good was Tsingtao’s performance? Just look at the chart below:

Now the Chinese beer market is very competitive and it may be too late to invest in Tsingtao. So what’s the next Tsingtao?

When investing in China, we always need to take the Chinese cultural factors into our consideration in order to increase our winning chance.

To control population growth in China, Chinese government has enforced the “1-child policy” very long time ago (at least as early as my first visit to China more than 30 years ago).

Any family violated this policy and raise more than 1 child is subject to heavy penalty imposed by the government.

As this policy applies to all families regardless of their income level, it is easy to imagine that wealthier parents will devote whatever they can afford to their only child in the family. Applying this fact to Maslow’s theory, milk and food juice shall have a very promising domestic market potential.

In China, the leaders in milk and fruit juice are Mengniu Dairy (HK:2319) and Huiyuan Juice (HK: 1886) respectively. The share price performance of Mengniu is shown in the following chart.

Huiyuan Juice (HK: 1886) was just listed on HK Stock Exchange last Friday (23 Feb 2007), its stock price went up by 79% in just 2 days. With P/E of 66x and 84x respectively, it may be irrational to invest in Mengniu and Huiyuan now regardless of how those sell side analysts present the rosy growth stories.

What if there is a company with a historical P/E of 25 and still have a high exposure to the Chinese beverage market? The answer is Groupe Danone (ADR: DA)

Groupe Danone is a French food company that primarily produces dairy products, biscuits and cereal products. The Company's portfolio of brands and products include Danone, a brand of fresh dairy products; Evian and Volvic for bottled still water. It has also a well executed China strategy, it owns 51% in a joint venture with Mengniu Dairy to produce and market yogurts in China.

It also owns 22.18% of Huiyuan Juice, the red hot stock just listed in Hong Kong. As early as in 1996 Danone has invested US$43 million in five Wahaha (China's leading domestic beverage producer) factories and owns 51 per cent of each of the subsidiaries.

With 14% of operating income generated from Asia in 2005, China contributed Euro 1.18B sales and ranked no. 3 in its top 10 country list by revenue, plus a proven track record of well executed China strategy, it won’t be too long before Groupe Danone becomes a prominent foreign player in the Chinese beverage market.

One added advantage investing in Danone is that it can provide a comparatively better reporting transparency, something those Chinese firms are lacking.

China 3G Status Updated and China Mobile

Last week an unofficial source has rumoured that China Mobile Limited (0941.HK NYSE: CHL) is ready to place orders to manufacturers for TD-SCDMA infrastructure network equipment valued at RMB10.4B (US$1.33B).

TD-SCDMA is China's homegrown 3G standard that like any other 3G technologies will provide high speed Internet access, seamless video and multimedia services.

Though Mr. Wang Xudong, who heads the Ministry of Information Industry (MII) still has not confirmed the 3G licensing timeline, he has openly confirmed that there will be 3G service in China for Olympics in 2008.

This week the Chinese authority has also announced that the TS-SCDMA trial network will cover 10 cities including Beijing, Shanghai, Hong Kong and other Chinese cities which co-organize the 2008 Olympics.

It is widely speculated that China Mobile will be appointed by the government to run the home grown standard. It is a dilemma to the Chinese leaders about which operator shall bear this responsibility. On one hand the country must promote and adopt the home grown standard so as to avoid or reduce the amount of royalty to be paid to US and European technology companies as what it did for 2G, so the strongest player probably is the best candidate because it has the cash flow and market power to push the standard; on the other hand any potential damage to CHL’s business is the last thing the authority wants to see.

CHL has gone up by over 40% in past 6 months, the main storyline has been around CHL’s growth potential with new 3G services. However, once it is confirmed that CHL will run TD-SCDMA, I expect there will be short to mid term pressure to the stock as the industry is saying the TD-SCDMA standard is immature and there is a lack of production scale that will result in a lowered CHL profit margin due to higher 3G handset cost subsidy.

Taking this potential risk into account, I am still positive with CHL’s mid to long term future as I believe:

• 3G role out is a slow process with manageable CAPEX impact
• 2.5G voice and value-added service will continue to grow healthily

My analysis as follows:

No matter which standard is being chosen, the national launch of 3G will be a slow process because there is no commercial reason to be hurry. CHL’s GSM network is still expanding rapidly, for the last 3 months in 2006, it has signed up 50M new subscribers monthly which is equivalent to an impressive monthly grow rate of over 10%.

From the figure below (source: CHL interim report), we can see that the YoY 1H06 value-added service (VAS) revenue has grown 37.1%, and over 70% of the total VAS revenue was came from SMS and voice based value-added services (e.g. IVRS service such as dialing a number for weather forecast, etc) which are of low bandwidth or voice based applications. Of the remaining 30%, they are mainly MMS traffic and ringtone download which are still not bandwidth hungry type of applications.

From all the numbers, we can conclude that valued added service revenue still has much room to grow even without the high data rate 3G technology, and the demand for high data rate service is in fact not there yet.

To further substantiate my rationale, let’s look at CHL’s deployment history of its GPRS service (the GSM version of 2.5G data service). The service was launched in China in 2001, however, as of 2004 CHL is still buying new network equipment for different provinces. It means CHL has taken a phrase by phrase role out approach instead of a national roll out in one go. The past history when Chinese companies invested heavily and blindly on capex without solid business plans was long gone. In 1H06, CHL has invested US4.1B in its profit making GSM network expansion, which is 3 times the US1.33B TD-SCDMA trial network investment it is rumored to make. I expect the build up of 3G assets will be slow and hence it shall not impose a huge downside risk to CHL’s financial performance as its 2.5G voice and VAS services will continue to grow healthily. Major 3G investment will not happen until such bandwidth hungry killer applications are identified. (by the way, as of today 3G operators worldwide still cannot identify such applications yet!)

In Vodafone’s (VOD) announcement this week about its acquisition of 67% holding in Hutchison Essar, it mentioned that mobile penetration is China is already 40% while that in India is only 10% and how the Indian market can deliver long term growth to Vodafone. However, I would look at China (CHL) as a lower hanging fruit comparing to Indian market in which the timeframe to fully materialize the potential market opportunity into profit is still unknown.

"Face" Factor is critical in analysing Chinese market trend

Policy risk is among the highest risks for any investment in China, as China is famous for unexpected and sudden change in its policy. In order to minimize our exposure it is important for investors to understand Chinese culture and apply it in our market analysis. If we only look at hard facts and numbers, chances are we will miss out the most important part of the true message.

There are a lot of well written articles recently about ‘Chinese market bubbles’, however, I’ve not seen too much coverage about this very fundamental but important factor.

I understand that there is nothing more important than ‘Face’ in our culture. ‘Face’ (面子in Chinese) has the meaning of pride and dignity.

Here I’m not only talking about the ‘Face’ of the Chinese leaders (which is itself important), but also to the ‘Face’ of the country which will affect the sustainability of the Chinese economic growth.

‘Face’ is especially important for China from now to 2010. Beijing Olympics will be held in 2008, and the Shanghai Expo will be in 2010. Nothing is more important than to show case these two global events to the world, in order to update the global visitors about what is China; why is China a good business partner; why is it a win-win to do business with China; what sort of infrastructure is in place to support businesses, what is the quality of Chinese people nowadays; and so on. If China failed in this once a life time opportunity, the leaders and the country as a whole will loss 'face'.

I want to show you some examples of what our country is doing, down to very detail behaviour, to support my rationale:

• The Chinese government has recently provided training to the customs officers and asked them to be friendlier to visitors with smile on their faces. If you have visited China previously, you probably noticed that those officers were very cold.

• The government has also taken actions to standardize the proper English translation of restaurant menu. (Previously those translations were so bad that you have no clue what they really mean. Look at "stewed bean crud”; "badly cooked starch cubes” or “fish in first position")

Why is the Government doing all these? To prepare our country for the grand reception of huge number of global visitors coming to China and provide them good experience so that China can have 'Face'.

How does ‘Face’ factor relate to the debatable bubble? My view is that for sure the Government will try to manage the over-heated market by different means, such as open statements from senior government officials about their view of the market; leveraging high profile expert’s opinion [See Jim Rogers’ opinion here], and introduction of new policy.[China has banned the usage of re-finance mortgage to invest in stock market]

High volatility is expected, however, it is important to understand that China's objective is to manage the heat of the market in a controllable manner before a real bubble is formed. Market correction is not the same as bursting of bubble, I will not believe the leaders would have any intention to collapse the market. Just think about if the market is collapsed; do you think the immigration officers can still wear smiling faces to welcome visitors? How can the leaders show the world the result of the stock market reform (conversion of stated owned shares to free floated A shares in stated owned enterprises) and the promised healthier market ? If a healthy equity market cannot be shown to international investors, how can a debt market be created which in turn will directly affect the risk managment capabilities of listed banks and manage the non-performing loan problems? The country will lose 'face' if any of the above failed.

If you are short term (in terms of weeks) speculator, this may not be a good moment for you to play the Chinese game. If you are looking longer horizon of 2-5 years, I still believe China can beat the other emerging market returns by a high degree on a risk adjusted basis.

This week the authority has approved 5 local equity funds with total value of RMB30B after putting a stop for 2 months. This may be a sign from our leaders that "Party is allowed but do behave yourself".

I still have a long position in CAF (see here for our blog's recommendation), and I will maintain my position at least untill the Olympics party is over.

Chinese Banks: A Non-Traditional Approach to Predicting Their Performance

中文版請按此

The most commonly used traditional valuation approaches are DCF model and PE comparables, and each has its own intrinsic flaws. In DCF method, analysts are required to make assumptions on a firm's initial growth rate; terminal growth rate and in interest rate trend. The outcome share price is also highly sensitive to those assumptions. Analysts generally will adjust those parameters until the result is within a reasonable range. I always doubt the usefulness of DCF model as there are so much guesswork involved.

In using PE comparables, market PEs are affected by supply/demand of the stock and investor's sentiment about a particular sector. Hot sectors (like PRC companies recently) are unavoidably overpriced.

As we all know, stock price is a reflection of investor's view about a company's future earning power, historical performance data hence would be of little value in forecasting a company's future. In most cases this is absolutely correct, however, as we know China is an interesting country and counter-intuitive things do happen.

For the three listed Chinese state-owned banks, I believe their historical performances do have predictive power to their future performances. My rationale is based on the following three China specific factors:

The Duty To Support Government Policy

Chinese state-owned banks [Industrial & Commercial Bank of China [ICBC], Bank of China [BOC], China Construction Bank [CCB], Agricultural Bank of China [ABC]] carried the role as China's policy banks. By 'policy bank' it means their activities are more of political rather than commercial in nature. For example, if the government's policy is to support the agricultural sector, banks will offer policy lending to farmers and companies within the sector without proper consideration of commercial risk. That explains the astronomical size of NPL (Non Performing Loan) inherited with the banks before their listing. Although they are now listed (in Hong Kong as H-share) and are supposed to operate in a more business oriented fashion, I believe their obligations to support government policy still remain. That is why foreign investors are still restricted to own no more than 19.9% of share in those stated owned banks so that government can still maintain control of the board and management.

Management and Company Culture

Even though the banks have invited foreign financial institutions as strategic investors as part of the listing process, they are only minority shareholders and their capability to influence the management are in doubt. Though banks such as China Construction Bank and Bank of China had replaced their senior management teams and recruited professional management from overseas, in those huge state-owned enterprises with long history, it's easier said than done to change the company culture to a truly professionally run organization.

Tale Of Two Markets

Lastly, banks are having their hands tied in improving credit risk management due to the immature credit market as opposed to the rapid developing equity market in Shanghai and Shenzhen. The introduction of SHIBOR (Shanghai Interbank Offer Rate) last month is a significant milestone in China's credit market, however, it will still take a long time before instruments such as interest rate swap and credit default swap [CDS] are available and become popular. Those instruments are essential to the securitization and efficient transfer of banks' credit risks to market participants.

Because of the above reasons, I believe there be no significant changes in the banks' future relative performance comparing to their past and hence historical data can offer certain amount of predictive power.

As the biggest problem with all banks is non performing loan [NPL], I would use NPL as a major parameter to rank the banks' historical performance.



As can be seen from the table, in 2002 (which was the year prior to the government's capital injection to package the banks for listing) China Construction Bank's non-performing loan ratio (22%) is the lowest among the three, while that of ICBC is the worst. To take into account of the different branch network size, I created the ratio [(nonperforming loan %) / (number of branch)] and that will give us a feeling how worst is the situation per branch per bank. With this ratio Bank of China is the worst performing bank.

Now let's look at their profitability. As the tax rates of the banks also differ, I've used pre-tax profit as comparison. (It is expected that in 2008 the Chinese Government will reform the tax policy and all banks will have the same tax rate.) Similarly I computed the per branch profit contribution per bank. Again China Construction Bank performed the best.

From the above analysis, CCB is historically the best performing bank in terms of both credit management capability and profitability, while Bank of China is the worst.

We also noticed that CCB was also the first stated owned bank listed overseas. This is by no means a coincident. The Chinese leaders have to ensure the success of the first listed so as to set a stage for the others, as such it is reasonable to assume that the leaders should have selected the best bank to be the pioneer. Who else would have better insider information than the Chinese leaders? It would be your decision to bet with the Chinese leaders' choice or analysts' DCF models.

Evan though there is no direct channel to invest in CCB, we can still indirectly invest in ETFs with Chinese exposures. Before we make our investment to those ETFs, it would be wise to take a look at their top 10 holding first.