Newsletter August 2007

Strong Stomach Needed Investing in Chinese stocks can be nerve racking. Two to three percent price swings a day are common place many times amplifying into five percent over the course of a week. Who has the stomach for that? Besides, mainstream media likes to highlight when indexes tumble yet they tend to overlook when the same index makes a comeback. There is not much fanfare about the Shanghai Composite these days, yet the mainland index is at all time highs with no sign of a slowdown. Hong Kong listed Chinese companies, called H-shares, are at record highs, just as are their U.S. counterparts. In Hong Kong, the Hang Seng China Enterprises Index (HSCE) is a great proxy to track mainland Chinese companies. This freefloat capitalization-weighted index is comprised of H-Shares listed on the Hong Kong Stock Exchange and included in the Hang Seng Mainland Composite Index. The base value of this index is 2000 as of Jan 3, 2000. This index replaced the old HSCE index on Oct. 3, 2001. There is no such index in the U.S. as of yet, however there is a quasi index that helps investors to navigate. This is the iShares FTSE/Xinhua China 25 Index, or simply FXI. By definition, the iShares FTSE/Xinhua China 25 Index Fund is an exchange traded fund incorporated in the USA. The Fund seeks investment results that correspond to the price and yield performance of the FTSE/Xinhua China 25 Index. The Fund invests 90% of its assets in the underlying index, which represents the performance of the largest companies in the China equity market. As the following chart suggests, there is a very strong correlation between the Hong Kong and U.S. listed Chinese stock universe. As a result, U.S. investors are reassured that  they enjoy basically the same exposure to mainland Chinese stocks as those of Hong Kong.  Additionally, the overall trend is up. So what’s the problem? The problem is that both the HSCE and FXI are extremely VOLATILE. At least by our standards. If the DJIA drops or gains over 100 points, it makes headlines. Given the current range of 13,000-14,000 points for the Dow, that 100 points swing translates to just a 0.76 percent change. On the contrary, if the Shanghai Composite or FXI changes 0.75 percent a day, it is considered as a “non event” or  “boring day”. In addition to our gut feel, we need something to help us better understand the nature of the Chinese stock trading. Using a ten percent filter, the following chart marks periods when the FXI changed over ten percent. One segment of the blue line represents one such event.. The white line represents the actual value of the FXI. As the chart suggests, there have been exactly 20 times when the value of FXI has changed over ten percent, since October 2004. This number is just 2 for the DJIA over the same period of time, as the DJIA is up over 26 percent since then. In other words, it is ten times more often to see a ten percent change within the Chinese stock universe than in the U.S. As long as the overall trend is north, investors should not have problem with that. But gain has not come easily. Five times out of the twenty occurrences, the ten percent change meant negative ten percent. And unless you had the nerve to sit it out, you were selling at the bottom. To understand better what these ten percent ups and downs mean, let’s take a look at the chart between 10/12/2006—4/12/2007. During this short 6 month period, FXI rallied up over 20 percent peaking at Dec 31, 2006. Then it tumbled down over 20 percent just to see the trend reverse again and go up over 40 percent! This volatility requires a strong stomach. Besides empirical and emotional measures, we went on to find understandable statistical functions to better understand the nature of trading  the Chinese stock universe. As on the first page we explained, the FXI serves as a good proxy for the U.S. listed Chinese stock universe. So we will apply these statistical measures on the FXI. Before we expose you to the charts on the following pages, we need to explain our methodology. We looked up daily and weekly (Monday to Friday) changes in the DJIA and the FXI for three years and categorized those changes. We used the generally accepted measure of standard deviation (SD) to measure the average change. One Standard deviation below and above the average change represents 75 percent of all occurrences. In other words, assuming the average change for the DJIA is around zero—there is a 50-50 percent chance for an up or a down day—and the SD we calculated is 0.6%, it means that there is a 75% chance that the DJIA will change between negative -0.6% and positive 0.6% for any given day. To be accurate, we found that out of the total of 680 days we examined, 490 times the DJIA did change between +/-0.6 percent. This is graphically represented on the first chart, right side, middle column. The same chart reveals that 82 times the DJIA has gained over 0.6 percent but less than 1.2 percent and it occurred 18 times that the DJIA leapt over 1.2% a day. Now, looking at the same first chart but venturing into the left side titled “FXI”, we see that while most of the time the FXI has changed between +/- 0.6%, to be accurate it occurred 285 times, the second most often occurring event is when the FXI changed over 1.2 percent! In other words, while the 0.6% range describes the trading characteristics of the DJIA very well, it is certainly not a good measure for the FXI. Now we know that for the DJIA, the change for any given day is typically somewhere between +/- 0.6%. Given the current range of the DJIA around 13,500 it gives us a change of 81 points. Statistics has taught us in addition that 95 percent of the time the DJIA will be between two SD. Translating this into point change, it gives us a range of 81x2=162 points. In other words, 95 percent of the time the DJIA does not venture above or below 182 points to the previous close. While the 0.6% range is a good measure for the DJIA, it is certainly not appropriate for the FXI. So we calculated SD for the FXI also. This is represented in the second chart where the range is set for the FXI. Not surprisingly, SD was 1.5%, or two and a half times more than that of the DJIA. It means that 75% of the time the FXI will swing between minus –1.5% and plus 1.5% a day. It also means that 1.5 percent change a day in not out of ordinary for the FXI. Looking at the left side of the bottom chart, out of 680 days we examined the FXI had 510 times a daily change of +/- 1.5%. In addition, 77 times the FXI gained over 1.5 percent but less that 3% and 23 times the FXI rallied over 3% a day! On the negative side, FXI lost 54 times between 1.5-3% and 17 times over 3%. Not surprisingly, it was extremely rare, occurred only once, that the DJIA lost over 3% while it never occurred that the DJIA gained over 3% during the examined period. Leaving statistics behind for a moment, all these numbers tell us one thing we want to highlight: while we, in the U.S., are accustomed to 0.6 percent changes in the DJIA, the Chinese stock universe behaves differently. Chinese investors have to set their minds that a price swing of a 1.5 percent magnitude of a Chinese stock is just as normal as a 0.6 percent change in the U.S. After this statistical quagmire, no one wishes going back to it. But we have to. Besides daily changes, we examined changes over a week. We wanted to see what is a typical change in the DJIA over a week and what it is for the FXI. As the following chart reveals, a typical weekly, five days apart,  change for the DJIA is somewhere between negative (1.5) to positive 1.5 % change. As the right hand side of the top chart reveals, 75 percent of the time the DJIA changes between this range. The range is obviously different for the FXI. As we calculated, a typical weekly change for the FXI is +/-3.4 percent. This is represented on the second chart. And while it happened 22 times that the FXI gained over 6.8% a week, it never happened with the DJIA. Again, investors interested in Chinese stocks have to set their minds that a weekly change of 3.4 percent is very normal while a change between 3.5-6.8 percent is not out of the ordinary either. We hope that by using this sophisticated statistical method we can interpret the results simply enough to show what to expect on a daily and a weekly basis when we are dealing with Chinese stocks. As we knew high return requires high risk, but at least now we have a better understanding of how big risk and price changes are normal or are out of sync. And finally, we want to address an issue that has been out there for quite some time yet we did not have the answer.  And this is the lack of exposure to the Chinese banking system for U.S. investors. As we know, only HSBC Holdings is trading on the NYSE under HBC ticker symbol. Yet, we need more that just this global bank and we think we have some sort of solution for this. We found that China Life Insurance Co. (NYSE:LFC) correlates very closely to one of  the largest banks in China, Bank of Communications (HKEX:3328). As we argue in the Stock of the Month section on page 5, LFC offers an excellent investing opportunity. To access this Newsletter and other research content, please register!