Newsletter September 2006

Stocks on the risk scale   Investing in Chinese equities is a risky business. But one can ask: how risky? Is there a reliable risk measure geared specifically to investors who navigate in the Chinese stock universe? Our current Newsletter addresses this very important question and will shed light on stocks that are relatively safe and stocks that you should avoid. First, let’s talk about the obvious. The first chart, Correlation between the DJIA and the Hang Seng, shows the performance of two common indices in the last ten years; the DJIA and the Hang Seng. We chose the Hang Seng to study Chinese stocks for at least two reasons. First, this exchange is the most liquid to trade Chinese equities. Second, Hong Kong Stock Exchange (HKEx) is the home market for most NYSE listed Chinese stocks. As the chart shows, there is an obvious correlation between the two exchanges. When the Dow heads north, so does its Chinese counterpart. And when things turn sour in Asia, it has an effect on the U.S. index as well. Actually, the correlation between the DJIA and the Hang Seng index is 0.89. Remember, perfect correlation is 1 and 0.89 is very close. From this perspective investing in Chinese stocks is nearly as risky as investing in U.S. equities. Surprised? You shouldn’t be. As economies and currencies became more and more interdependent thanks to globalization, it makes perfect sense that stocks in Asia are sensitive to U.S. interest rates. Should the U.S. economy slow, it certainly will have a chilling effect on Asian export oriented economies and thus equities. Having said that, e.g. strong correlation exists, the volatility of the two indices is remarkably different. This may suggest that investing in Hong Kong is more risky, however volatility and risk are not interchangeable. If you lose your shirt in Asia and decide to diversify away into U.S. stocks, you will continue to head south. The scale will be different but the direction will be the same. So at this point you’d be better served weathering the storm in Asia and making sure you hold positions when market sentiment turns around. With this strategy, you can ride the massive turnaround that will outshine a modest DJIA gain. From this perspective Hong Kong does not offer a safe haven for U.S. investors. International diversification is regarded as a hedge but it’s certainly not the case with Hong Kong. However Hong Kong does offer an alternative and certainly an increasingly tempting one for value investors. One might say: this is all good, but how can I achieve returns similar to the Hang Seng Index? This assumes that I can’t buy all 33 stocks that make up the index. There is at least one exchange traded fund (ETF) that tracks the Hang Seng index very closely; the iShares FTSE/Xinhuna 25 Index (FXI). As the chart below shows, FXI has been a very close proxy for the overall Hong Kong market and, since it is trading in the U.S., investors can buy and sell this ticker just as if it was a stock. There are clear advantages: instant diversification, low entry and exit costs, just to mention a few. And regarding risk, there is no better way to minimize company specific risk than through diversification. As a rule of thumb, investors should own around 30 stocks to achieve acceptable stock specific risk. Buying into ETFs allows investors just that. Chinavestor’s subscribers can recall how many times we highlighted the importance of diversification and pointed to this specific ticker, FXI, as a way to achieve this. We believe that advice remains sound. Another way to lower risk is to trade or invest in stocks that are easy and cheap to buy and to sell. We highlight the importance of our July Newsletter in which we elaborated on the topic and published a major study on this area. That study involved a lot of data mining and thorough analysis. We introduced three different measures. One, how much money it takes to move a stock up and down one percent. Two, how many shares one has to buy or to sell to move the stock price up or down one percent. And three, how big an impact USD 1 million has on the stock price. Looking at those results from a  risk perspective, one way to lower risk is to trade on the HKEx whenever possible. Hong Kong offers the  best “market quality” for Chinese stocks. To measure market quality we looked into the following areas: price, liquidity, volatility, execution speed and certainty of execution. Being stock specific, we found the following stocks offering the best execution. They are NetEase (NTES) and Baidu.com (BIDU) from the NASDAQ, Sinopec (SNP), PetroChina (PTR), CNOOC (CEO), HSBC Holdings (HBC) and China Life Insurance (LFC) from the NYSE and again Sinopec (0386.HK), China Mobile (0941.HK), China Telecom (0728.HK), PetroCchina (0857.HK), CNOOC  Ltd. (0883.HK), Huaneng Power (0902.HK), HSBC Holdings (0005.HK) and China Life Insurance (2628.HK) from the Hong Kong Stock Exchange. Another way to define stock specific risk, actually a very common and easy to understand one, is to look at the stock’s beta. By definition, beta is a measure of a security’s systematic or market risk. While most stocks move in the same direction as the stocks market, the level of the beta indicates the degree of correlation between the security and the market. The market is the benchmark and has a beta of 1. In other words, stocks with beta close to 1 correlate with the market very closely. If the market goes up one percent, so does the stock. Higher beta makes stocks more risky because if the market turns south and loses one percent, high beta stocks will fall twice or thee times that much. The table above lists 32 NASDAQ and NYSE listed Chinese ADRs sorted by the impact of $1 million buying. As expected, stocks that are more resilient to buying pressure, large liquid names, have generally lower beta. To put these numbers in perspective, the top ten stocks with the biggest resilience to buying and selling pressure follow the market closely and have a beta of 1.53. In contrast, the bottom ten stocks on our list, stocks that are very sensitive to buying and selling, have a beta of 2.95 on average. This finding reinforces the conclusion of our July Newsletter that stocks with the best execution are less risky. Looking at the beta measure alone, the top five stocks follow the overall market the closest: China Life Insurance Co. (LFC), The9 Ltd. (NCTY), Ctrip.com (CTRP), HSBC Holdings Plc. (HBC) and CNOOC Ltd. (CEO). Our final measure of stock specific risk is a very unique method. It looks at individual stocks and compares stock price reactions to significant news. By significant news we mean analyst upgrades or downgrades, earnings reports, guidance or sales related announcements, just to name a few. The idea behind this method is to find stocks that are moving in line with market expectations. These stocks are less risky than, for example, those that report better than expected earnings and guide higher for the following quarter and yet experience a price decline. We employ the following methodology: we look at each stock price history aligned with a significant news calendar. Then we rate  the stock as to how it trades versus expectations. Stocks that trade best in line with expectations receive a maximum score of 3 while stocks with the most unusual price characteristics receive a score of 1. Stocks with average reaction to news receive a score of 2. The scores are displayed in the far right column in the “Overall Ranking” table. With that Significant News score, our table is complete. It takes additional statistical analysis to finally rank the stocks based on these four different criteria. But this table represents our overall findings when it comes to risk. Again, this Newsletter revealed that investing in China is not as risky as one would think. Actually the Hang Seng Index of Hong Kong correlates very closely to the DJIA. The key is diversification in order to minimize stock specific risk. We suggest the iShares FTSE/Xinhua 25 Index as a good alternative to achieve diversification for low cost. However if investors want to go stock specific, it’s HSBC Holdings (HBC), China Life Insurance Co. (LFC) and PetroChina Co. (PTR) that are the least risky stocks and China Finance Online (JRJC), Brilliance China Auto (CBA) and eLong Inc. (LONG) are the most risky stocks based on our analysis. 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