I have to start this week with a disclaimer. The following text is for your reference only. If you act on anything written here you are doing so on your own head.
The style of this week’s newsletter is a bit of a departure because I’ve written it in the form of one of those office memos that people are always writing. With all the financial markets madness going on, I thought I would return to some simple portfolio management, seeing as every fund manager in town will be doing the same in the next three weeks. It’s called rebalancing, or window-dressing.
What ever you want to call it, it has an effect on equity prices in December. Usually, it’s not really noticeable, but fund managers have a great opportunity to toss out their rubbish holdings and bring in new blood ahead of the end of one of the worst years for equities on record. Expectations are so low, that fund managers can show terrible results and no-one will blink an eye. So, here is a rebalancing idea for your tired and beaten down equity portfolio.
The effect of the first of many stimulus packages from China is already being felt, with the Shanghai Composite having broken its medium term downtrend on November 14 – in heavy volume. The potential for the index to retrace back to 3,000 (+45%) in six months is high. If you can’t buy A shares, you can take advantage of this recovery by buying the A50 ChinaTracker EFT (02823.HK – HK$8.97). A level of 3,000 on the Shanghai Comp would translate in HK$13.00 for the A50 (which has a correlation with the Shanghai Comp of 0.99).
Shanghai and A50 Tracker broke medium term resistance
It is likely that China will use its massive fiscal reserves to stimulate its economy in the next 12 months. The first step in this process was delivered on November 9th. More measures are likely to be introduced in the months ahead (including further interest rate cuts). In order to expose your portfolio to the upside that PRC fiscal and monetary stimulus measures are likely to deliver (both tactically and from a strategic point of view), the portfolio should be rebalanced.
Having reviewed a list of potential stocks that could be used to rebalance, four candidates stand out as potential inclusion. The screening process involved extracting China-only exposed companies within the top 200 companies by market capitalization as at November 20 (as these companies will be large enough to take advantage of the stimulated growth of China’s economy). Sectors that were excluded: 1) financials, which are about to fund China’s spending, probably at unfavorable terms as well as suffering from rising NPLs 2) there are no real estate companies as property prices are expected to remain weak, as they continue their correction from overheated levels of 2007, 3) no export oriented companies due to weak consumption demand overseas, 4) steel companies are excluded because of declining steel prices, 5) mining companies are excluded because declining global metal prices, 5) automakers are excluded because of their weak financial conditions of their overseas partners.
Although China’s interest rates are forecast to decline sharply in coming months, the list has excluded companies with high gearing, with an emphasis placed on companies with high cash levels (falling interest rates will encourage these companies to invest surpluses in their businesses). The list of 84 companies was then reduced to 38.
Stocks that would benefit from central government stimulus packages were given priority. In the case of all the stocks in the proposed list, the recent decision to inject new capital into ailing CITIC Pacific means that there is a precedent for support by Beijing of Hong Kong-listed corporates with strategic importance to China (something that would lacking for Hong Kong companies or non-SOE mainland companies). The decision to pick stocks that are state-owned provides a degree of downside-protection. China will not make the same mistake it made with the ITICs during the Asian Financial Crisis or the repeat the recent mistakes made by the US Government.).
The following stocks/units were then chosen as being likely to benefit from fiscal and monetary stimulus measures and therefore a general improvement in the Chinese economy as well as lender of last resort protection. The picks were assigned into two categories: tactical/growth and strategic/value, with the former given a six month investment time horizon, while the strategic stocks should be held for a longer term.
China Communications Construction (1800.HK – HK$6.75) – Market cap HK$30b, 14x PER, 1.7% yield. Beta: 1.25. The company has a dominant position in the PRC port infrastructure construction and design market. New business penetration into railway construction is timely as the government increases infrastructure spending. Raw material price declines should support margins. Net profit growth of 20% a year is expected. Price target is HK$9.40 (+57%). China Railway Construction (1186.HK – HK$10.48) – HK$22b, 27x, 0.8% Beta: 1.35. The principal activities of the Group are construction operations, survey design and consultancy operations, manufacturing operations and other businesses, including real estate development and the provision of logistics services that relate to the Group’s main business. The Group also engages in capital investment operations in Build-Transfer, Build-Own-Operate and Build-Operate-Transfer projects. CRCC should become one of the largest beneficiaries of surging government investment in the railway market (with reports of investment of Rmb2 trillion – 33% higher than the government’s planned Rmb1.5 trillion, which was announced in the 11th five-year plan over 2006-2010). Based on the new government investment plan, CRCC’s revenue from the domestic railway construction market may reach over Rmb717 billion from 2H08 to 2011, 90% higher than current estimates of Rmb378 billion. The estimate is based on 1) railway projects are under construction an average of 3.5 years, 2) CRCC maintains its leading position in the railway construction market with a 43% share, 3) construction investment accounts for 83% of the Rmb2,000 billion investment. The company has a net cash position, but has forex exposure (Yen, US$, A$). Raw material price declines will support margins. Price target HK$16.10 (+61%). Strategic picks included: Beijing Enterprises (392.HK – HK$26.40) – HK$32b, 15x, 2.5% Beta: 1.06. Beijing Enterprises is a public utilities and infrastructure owner (gas, water, roads) mostly around Beijing. Revenues are expected to grow 20% a year as the city continues to grow. It has low debt levels for a growing utilities company (gearing 8-9%). Company has bought back 2 million shares this year at an average price of HK$24.67. Price target HK$35.50 (+48%). Shanghai Electric (2727.HK – HK$2.50) – HK$7.4b, 10x, 3.0% Beta: 1.30. The principal activities of the Group are the design, manufacture, sale and servicing of products and services in the power equipment, electromechanical equipment, transportation equipment and environmental systems industries. China’s equipment makers have three years of orders and full capacity utilization, with expected higher demand from infrastructure stimulus packages. SE has RMB10 billion in cash, and no forex exposure. Price target HK$3.18. (+59%).
Purchases of these stocks/units will be conducted over a period of three months, so as enable an ability to adjust the average price achieved, as well as provide an opportunity to capture expected volatility – especially over the year-end, when window dressing is expected to be heightened.
Based on the beta of each stock and the assumption regarding the A50 ChinaTracker’s potential performance in the next six months, the expected return of the portfolio using various target levels for the A50 Chinatracker would be as follows, with an optimum capital gain 56% of the sum invested forecast.
Sensitivity of returns based on various A50Tracker levels
Individual stocks would generate returns shown below, based on the historic beta of each stock and the expected return of the A50 Tracker.
Expected returns for individual stocks
The portfolio would produce dividend of 2.8% in 12 months, which would be more than sufficient to cover the cost of holding the positions.
The average recommendation strength of the portfolio is 4 on rating of 1 to 5 (five being a strong buy). All the stocks are widely covered by analysts, with analysts from Morgan Stanley and Goldman Sachs recommending the four stocks. In fact, Morgan Stanley’s regional strategist has included both 1800.HK and 392.HK in his model Asia portfolio.
I have to admit I’m quite impressed with the logic behind the recommendations and the returns look really attractive. However, there are two issues that are crucial to the whole strategy: first China’s Shanghai Composite needs to continue to decouple from the rest of the world. Even though China’s A share investors are remote from the rest of the world, it must be hard not to look at the Dow or Hang Seng and wonder if Shanghai should follow. Second, H shares are listed in Hong Kong. If the company has a dual listing in Shanghai, then there are pressures between the two shares. The premium in Shanghai can widen, but it is not an infinite piece of elastic. Finally, I am aware that local retail punters have been piling into the A50 Tracker recently (as well as Callable Bull Bear Contracts), after giving up trading covered warrants. They could exit A50 as quickly as they piled in. That explains the disclaimer at the beginning.
