China: Portfolio Strategy
China Stance-at-a-Glance
August 2008: Olympics cheer?
Despite signs of a possible resurgence of the global credit
crisis, divided views on China’s macro policy direction and
concerns over earnings, we see upside risks for H shares as
valuations are close to fundamentally-supporting levels. The
A-share market could remain in consolidation mode until
better macro and earnings visibility emerges.
H-share market: Upside risks in a range-trading market
H shares gained 5.3% on market speculation of potential policy easing by
the government before correcting by 3.1% in July due to the worsening
credit situation in the US housing/financial markets. With the H-share
index now trading at 12.7X forward 12-m P/E, which is meaningfully below
our calculated fair P/E range of 16X-18X, we believe valuations have
factored in a considerable amount of macro and earnings risk. Improving
inflation trend, currently depressed risk appetite, and potentially a
smoother-than-expected execution of the Olympics Games could propel
the HSCEI to higher levels within our expected trading range of 12,000 to
14,800 near term, in our view.
A-share market: Consolidation during Olympics
We expect A shares (CSI 300) to extend its consolidation mode and rangetrade
between 2600 and 3000 in August, as deteriorating corporate
fundamentals, concerns over potential share disposals, and unattractive
valuations should cap upside performance, but the govt’s explicit support
policies, and sluggish sentiment could support the potential downside.
Performance
In July 2008, our buy stocks lost 3.1% and our funding stocks fell 3.9%,
resulting in a positive spread of 78 basis points (bp) in local currency total
return terms. Ytd, our buy/funding spread is -0.5 pp. Since inception (April
2005), our buy/funding spread has been 186 pp.

Offshore market (H-share, red chip, P chip): Upside risks in a rangetrading
market
On May 15 2006, we published a report titled, China Strategy: Olympics 12000 odyssey, in
which we highlighted a bull investment case for Chinese equities for 2006 to 2008. In the
report, we forecasted HSCEI to reach 12,000 by end of 2008, the year in which China will
host the 29th and its first ever Olympic Games in Beijing.
With the opening ceremony of the 2008 summer Olympic Games just a week away, the Hshare
index is currently trading around the 12,000-level, fairly close to our previous yearend
index forecasts.
We believe there are two important points regarding investing in equity market that can be
drawn from the case above:
• Longer-term, equity market returns should be driven by earnings growth. Specifically,
HSCEI was trading at around 7300-levels on May 15, 2006 and if we multiply that by
the time-adjusted yoy earnings growth of 22%, 40.7% and 21.4% in 2006, 2007 and
2008E, respectively, the index level should have been at around 12,700-levels now in
theory. The theoretical, ex-post fair index value should be identical to the current price
if we take into account the changes in forward earnings multiple during the same
period (from 13X to 12.7X).
• Changes in the earnings multiples could however deviate prevailing market prices
from fair values in short term. HSCEI reached a historical high of 20,400 on October
30, 2007, and was trading at a substantial forward multiple of around 24.8X that time.
The expansion of forward multiple alone had contributed to a price return of around
90% (from 13X to 24.8X) from May 2006 to October 2007.
With the HSCEI now vacillating at the low-end of our expected trading spectrum of 12,000
to 14,800 and its forward valuations (12.7X) meaningfully below our DDM-based fair range
of 16X-18X, we believe the current price multiples have reflected a considerable amount of
the following risk factors and uncertainties:
(1) A potential resurgence of global credit crisis
Renewed concerns regarding the capital levels of the government-sponsored enterprises
(GSEs), Fannie Mae and Freddie Mac, as well as the recent failure of several regional
commercial banks and credit agents, have sparked fears of a potential revival of credit
crisis in the US and its contagion to the global financial system.
From a macro perspective, our US economics team thinks the decisive policy support from
the US government to the GSEs, which include an expansion of the existing credit line to
the GSEs and potentially direct purchase of senior equities or debts issued by the GSEs,
should already have relieved the immediate financial stress and fears in the US credit and
financial system, despite the fact that US economic outlook could remain gloomy in the
coming few quarters.
Contrary to the widely-held belief, our US economists believe the US government could
encourage the GSEs to continue growing their book of business to offset the credit
contractions in other private sectors in order to alleviate the negative economic impact in a
tight credit environment. From a fiscal perspective, our US economists believe the scope
of the GSE problems in the financial system should be well within the range of what the
federal budget can handle, if lawmakers deem it necessary.

Specifically, the “US$5.3 trillion burden” recently being highlighted in media actually
refers to the GSE’s holdings of mortgages and loan guarantees, which is not at all the
same thing as outright liabilities. It is certain that the US government would have to cover
any GSE losses if property and credit conditions further worsen, but we believe this would
be a much, much smaller number under any reasonable set of assumptions. Our specialty
finance analysts believe potential cumulative losses on the GSEs book of business could
amount to US$53 bn. Even if the federal government were to incur these costs, they are
one of many factors affecting the fiscal picture (a budget deficit of around US$500 bn for
FY08), and hardly the dominant one as it only represents less than 0.5% of US GDP.
On the banking sectors, federal regulators have closed seven institutions with combined
assets of US$37.9 bn, reducing the balance of the deposit insurance fund by at least US$5
bn (about 10% of the fund) so far this year. Our economists still believe that the Federal
Deposit Insurance Corporation (FDIC) has significant authority to deal with large failures,
by virtue of: (1) a deposit insurance fund; (2) its ability to borrow from the Treasury; and (3)
its ability to raise assessments on banks in the future to repay losses it incurs in the near
term.
(2) Policy direction from the Chinese government
Recently, we note that there has been much market speculation regarding a potential
monetary easing stance from the Chinese government in response to increasing lobbying
from the small-to-medium (SME) export-oriented manufacturers and cash-strained
property developers amid a difficult business environment, characterized by weakening
external demand, rising input costs, appreciating CNY and tight credit situation.
In accordance with our China economists, we believe the case for the Chinese government
to ease at this economic junction is weak at the moment, particularly after considering that
China’s 1H08 GDP is still growing at 10.1% in real terms and inflationary pressure (7.1%
CPI and 8.8% PPI in June) is still high on an absolute basis. We believe it would be
incrementally negative, not positive, to the macro outlook if the Chinese government really
opted for an easing stance, because easing policies are generally inflation-provoking,
something that the Chinese regulators are concerning over the past few quarters.
Our economists believe that the timing for the government to switch to a neutral/progrowth
policy stance will be dependant on how quickly the inflation pressures could be
brought under control. They think not only headline inflation needs to come down towards
5%, but it also needs to take place without the crutch of various administrative price
controls. Our economists envisage that the earliest that the government could possibly
start easing should be 4Q2008, but again the government’s stance on monetary policy
would be largely data-dependent.
To respond to the lobbying groups’ requests, regulators, in our view, are likely to adopt
selective micro and supply-side fiscal policies/reforms, which include reform measures
aiming at providing better financing to small- and medium-sized companies, specific
supporting policies targeting struggling exporters and tax policy adjustments such as
raising the minimum personal income threshold and broadening the VAT reduction
scheme for fixed asset investment.
For details, please refer to China Views: Policy path will be data dependent, July 28.
(3) Downward earnings revision
A majority of Chinese companies will report their FY08 interim earnings in August. While
only a handful of H-share companies have so far reported their interim results, more than
141 A-share companies, representing around 6.5% of the total A-share free-float market
cap, have released their interim numbers so far.

Based on the reported numbers so far, we note that aggregate A-share earnings have
grown 45.4% and 8.9%, on a net income and EPS basis, respectively. While maybe it is too
early to make comments about corporate earnings growth trajectory given the limited data,
we believe that investors have already built in a somewhat pessimistic earnings scenario
in their own investment frameworks and models by benchmarking their expectations to
earnings data being released so far this year.
Due to the negatively-skewed earnings expectations, we will not be surprised to see
favorable price reactions for certain underdogs during the upcoming results season. We
will keep a close eye on the interim earnings data and will publish our FY08 interim
earnings tracker in due course.
(4) Commodity prices are wildcards
Commodities generally had a tough month in terms of price performance in July amid the
market’s concerns regarding non-sustainability of high commodity prices against a
slowing global growth backdrop and a 2.5% rebound of the US dollar (DXY index) in July.
Also, the Federal Reserve Chairman Ben Bernanke suggested that there is significant
demand destruction in the US because of the high energy prices.
That being said, our commodities team continues to see upside price performance risks for
major energy-related commodities, oil in particular, in the near term, given that global
incremental supply remains tight for various structural and policy reasons, but demand
from the emerging markets and oil-producing countries continues to increase at healthy
pace. They maintain their 2008-2011 WTI spot oil price forecasts at
US$118/US$140/US$150/US$140 per barrel, with a possibility of a spike to US$150/bbl-
US$200/bbl over the next 6-24 months.
In the context of Chinese equity market, we see the relationship between oil and equity
following a “see-saw” process by which oil prices, or more broadly commodity prices and
equity market performance are usually negatively correlated in the late expansion or early
recession phases of an economic cycle.
If our commodity team’s forecasts are proved to be right, we see extended weakness for
Chinese equities if oil price sustains at above the US$150/bbl-level for this year and the
next. For details on potential impact of high oil prices on the equity market, please see our
recent report, China Strategy: Oil in crosshairs, dated July 30.
Upside risks in a range-trading market
As the HSCEI is now trading at the low-end of our previously-proposed trading range, we
see upside risks for the market as a whole, not only we believe the currently low valuations
are fundamentally-supported and have discounted a fair amount of negative macro/market
news, but we also expect the following two emerging catalysts could potentially help uplift
market performance in the near-term.
• Improving inflation readings. While the PPI inflation continues to hover at elevated
levels due to raw materials and energy price increases, we believe the CPI inflation in
China may have already peaked as the CPI has come off the 8%-plus plateau in
February to May to 7.1% in June. Our economists believe if the Chinese central bank
can manage keep the pace of monetary expansion in check, inflation is unlikely to go
out of control and could gradually recede around the 5%-level towards the end of
2008. Empirical evidence from different countries suggests that inflation and stock
price multiples are negatively correlated and we expect the same relationship to hold
for China. Additionally, an inflation downtrend should give Chinese policymakers
more flexibility in lifting price controls and liberalizing major commodity prices, which
should reduce policy risks premium and bode well for equity price performance, in
our view.

• A smoother-than-expected execution of Olympics. We note the recent reduction of
investors’ risk appetite is partly due to their concerns about the security and execution
issues, and the resulting negative impact to the equity market (high risk-premium),
regarding the upcoming Olympic Games. While we have no expertise to comment on
the national security issues, we believe a major problem (chaos) is unlikely given the
significant amount of resources that China has committed for the Games. If the
Games turn out to be a successful one, we think investors’ anxiety will be relaxed,
equity risk-premium could be lowered, and market could trend up as investors’ cash
ratio remains at high absolute levels.
Despite the emergence of the aforementioned catalysts, we expect market upside to be
capped by the uncertainties revolving around the global/US growth outlook, forward
corporate earnings growth, and commodity price movements. In sum, we reiterate our
range-trading stance for HSCEI, with an upper- and lower ranges of 14,800 and 12,000,
translating into 12.2X and 15X 12-month forward P/E, respectively. We would strategize
our portfolio in a way that its beta is reciprocal of our expected trading spectrum to
proactively monetize the potential direction returns in a difficult investing environment.
Domestic A-share market: Consolidation during Olympics
The A-share market (CSI 300) had been effectively oscillating between the 2600 and 3000
levels in July and we expect this range-trading pattern to extend in August as market
upside could be limited by deteriorating corporate fundamentals, concerns over disposals
of locked-up shares, and unattractive valuations, but the potential downside is likely to be
supported by the government’s explicit support policies, potential better inflation readings,
and already-sluggish investors’ sentiment.
On the positive side:
• Government’s explicit policy support. After pushing out a series of market-friendly
policies, including a reduction in stamp duty on stock trading and creation of a
separate exchange platform for non-tradable shares, Chinese government officials
seem to be increasingly relying on rhetoric and mass-media channels to influence
investor sentiment and stabilize market performance. Although we believe
government intervention tends to be ineffective in the long run, empirical evidence
suggests it can provide near-term support to the market.
• A more market-constructive inflation outlook. Similar to our analysis for the H-share
market, a reinforcement of inflation downtrend from the upcoming inflation readings
should bode well for market performance.
• Already-depressed market sentiment. Various technical indicators, trading statistics
and anecdotal evidence suggest that investors’ enthusiasm is diminishing and
speculative froth has subdued. From a technical and behavioral finance perspective,
we think a combination of persistently sluggish sentiment, shrinking turnover
volumes, and high cash positions could imply that, in absence of any major
exogenous shocks, further significant selling pressure could be limited in the nearterm.
Upside performance barriers:
• Deteriorating corporate fundamentals: We have been highlighting A-share earnings
risks to investors since last November. We continue to believe current consensus
earnings growth estimates (I/B/E/S) of 24.9% and 23.3% for 2008 and 2009 are too
complacent about an increasingly challenging business environment. We still have
not received enough data-points from A-share interim results to give an assessment
on corporate earnings trend, but based on the industrial enterprises’ earnings data we
get from the National Bureau of Statistics (NBS) and the poor cash-flow generation of

aggregate A-share companies in 2007 and 1Q08, we continue to see downside
earnings risks to current consensus market forecasts.
• Concerns over disposal of previously locked-up shares. We estimate that August
could be one of the most hectic months in the remainder of 2008 for disposal of
previously locked-up shares, which include non-tradable shares, and locked-up shares
from IPOs and placements. Based on our previous study, selling pressure from such
shares is more a function of price multiples and less so of the actual expiration
schedule. This implies that massive selling pressure, including those shares being
released in August, could re-emerge if market meaningfully strengthens from here, in
our view.
• Unattractive valuations. In appearance, CSI 300 is trading at an attractive valuation of
15.3X, based on consensus 12-month forward earnings. However, as discussed above,
we believe consensus estimates are lagging reality and are likely to be revised down
as time goes. If we subtract 10pp from 2008 and 2009 consensus EPS growth based
on our top-down earnings estimates, the effective forward P/E would be at around
18X, which is at the top-end of our expected long-term P/E range of 16X to 18X.
Moreover, although select A-share companies are trading at a discount to their Hshare
counterparts, the aggregate A-share market is still around 34% more expensive
than H shares. Please refer to our “China A-share Strategy: Back to reality”, June 25,
for more detailed analysis.
Overall, we think the conflicting forces mentioned above could keep the A-share market in
a consolidation mode and expect CSI 300 to range-trade between 2600 and 3000 until
more clarity on both the macro situation and corporate earnings resurface. Once again, we
stress the importance of selecting an appropriate entry point in this potential range-trading
market.