Newsletter December 2006

Tricky valuation   We have always prided ourselves with the performance of our stock picks e.g. “Stock of the Month”, our Growth and Conservative portfolios. Chinavestor premium subscribers, who receive the “Weekly Stock Recommendation”, are raving about the tool and its spectacular track record. And without a doubt, this year’s 65% performance so far is beating all standard benchmarks and indices. If you review last month’s Newsletter, we highlighted four stocks that we liked: China Mobile (CHL), China Life Insurance (LFC), HSBC Bank (HBC) and PetroChina (PTR). To highlight how strong these companies have performed, one of them just hit a milestone last week. There was no fanfare or celebration, but careful investors noticed when PetroChina Co. overtook Royal Dutch Shell Plc. to become the world’s second biggest oil company by market value. As the following chart shows,  the company’s shares have soared over 600 percent in the last five years, reflecting increasing energy demand on the Chinese mainland. China’s oil consumption has almost doubled in a decade, drawing investors to PetroChina and rivals China Petroleum & Chemical Corp. (Sinopec) and CNOOC Ltd. PetroChina’s value has jumped as oil prices rose and the company expanded output to satisfy demand in the largest energy market after the United States. Third-quarter crude oil and natural gas production increased 7.9 percent to the equivalent of  260.7 billion barrels of oil, the company said on October 16. “We will be more used to news that some Chinese companies become global leaders, and market size and demand within China are the key drivers to help them get there,” said Wang Lei for the Shanghai Daily Newspaper on December 1*. Exxon Mobil Corp. with a market value of $443.4 billion is the world’s largest oil company by market value. BP Plc., the fourth largest, had a market value of $222.2 billion at the close of London trading on Thursday. Going back to those four shares we highlighted, it’s worth noting that all of them, except HSBC, outperformed the Hang Seng  index in the last month. The average performance of these four stocks is just under ten percent, well above the Hang Seng index in the same period. It should also be noted that portfolio managers around the globe are finding it hard to beat the Shanghai Stock Composite. We are no exception. As the following two charts show, our stock picks  have handsomely beaten the Hang Seng (^HSI) on average but not the Shanghai Composite (000001.SS). Why is that? The problem is that the index’s compilers include initial public offerings (IPOs) right from their debut day, something most indices wait weeks or months to do so. As a result, the huge popularity of China IPOs this year has been giving the mainland index a regular and artificial boost. Bank of China (3988.HK) (601988.SS) surged 23 percent on its Shanghai debut in July, lifting the Shanghai Composite Index to close 2.2 percent or 37 points higher. Contributing a weighty 57 points to the market’s gain that day, the IPO wiped out what would otherwise have been a 20 point slide, according to Wei Gu from Reuters. Similarly, Industrial and Commercial Bank of China (ICBC)(1398.HK) (601398.SS) rose 5 percent on its first trading day in October, contributing 15 points. The Shanghai index fell three points that day, a slide that would have been 18 points without the IPO. The point is that it is meaningless to outperform an index like the Shanghai Composite because no one can get as many IPO allocations as they wish. This adds a disadvantage to anyone who wishes to benchmark against it. So there is obviously less focus on the Shanghai index in the future. Instead, we have identified another interesting trend to examine closely: the valuation of China’s financial sector. We have been following the financial sector very closely. Long time subscribers will recall our research, “Scrambling for China’s bank sector”, published more than a year ago. We have named China Life Insurance (LFC) four times in 2006 alone as our featured stock within the “Stock of the Month” section in our Newsletter. However shares of China’s banks and insurers have surged about 90 percent this year, making them some of the world’s most expensive financial stocks and sparking concerns the sector may be overvalued. The two charts above draw comparisons between valuations of top Chinese financial services firms and their global peers, using price to 2006 estimated book value. Looking at the insurance sector first, China Life Insurance (LFC) is almost three times more expensive than AIG and over four times more expensive than Zurich Financial Services group (ZURN.VX). The same trend is true for the banking sector. All four major Chinese banks are somewhere around  1.5 times more expensive than Citigroup ( C ) or Mitsubishi Financial (8306.T). Is it a big concern? The fact of the matter is that China is growing much faster than any other major region in the world. This often misused argument alone does not justify a higher valuation. Global investors have to consider market and currency risk in addition. Actually, it is the currency risk that makes these two sectors even more tempting. There is immense pressure on the Chinese government to let the Chinese currency, the yuan, float freely. Once that happens, the valuation of Chinese companies will rise in dollar terms. Imagine all the yuan denominated saving that the Chinese bank sector represents. As the currency gains, so will the value of banks. Remember, current stock prices reflect value of future earnings. As long as the market anticipates future yuan appreciation, the valuation of the Chinese banks will remain high. Another excellent example of potential future earnings is Baidu.com (BIDU), the number one Chinese search engine company. As the following screenshot displays, Baidu.com has been steadily recovering since February 2006. The company has kept delivering high top and bottom line growth while keeping profitability ratios high and constant. The company solidified its leading position among Chinese language search engines and skeptics in the investment community accepted Baidu’s high valuation. There have been six upgrades by major analysts since May 2006 and the good times seem to keep rolling. And a recent survey for the “Best International Stocks” of The Motly Fool included Baidu in the group of elite companies like Toyota (NYSE:TM), Sony (NYSE:SNE) and Nokia (NYSE:NOK). I think we should listen... To access latest Newsletter and other research content, please register!