Range-bound before the next bull market
􀂄 Recovering fundamentals
We expect rising investor momentum in the remainder of 2009, based on a higher
risk appetite, strong fund flows, more government pro-growth policies, and
improving earnings. Moreover, we see some important seeds being planted for a
bull market, including a low interest rate environment in the medium term. That
said, we believe a recovery in external demand and an easing of overcapacity
concerns are prerequisites for the next big bull run.
􀂄 Valuations do not look cheap
Offshore China equity indices are only 10-15% away from the upper bands of their
historical normal ranges. Global economic demand and China’s external demand
are still weak; therefore, we think that when valuations become a little stretched,
negative news could begin to have a greater impact on index prices than positive
news.
􀂄 We see 11% upside potential for the MSCI China Index
We set end-2009 targets of 60 for the MSCI China Index and 12,000 for the Hang
Seng China Enterprises Index (HSCEI or H-Share Index), implying upside of 11%
and 13%, respectively. Beyond 2009, we expect more upside risks as the global
economic problems pass. However, we think investors need to manage a rangebound
period before positioning for the next big bull market.
􀂄 Overweight financial, domestic consumption, and infrastructure sectors
We have developed five metrics to help investors assess valuations and earnings
momentum across different sectors. Combining this with sector fundamentals, we
Overweight the financial, domestic consumption, energy, and construction-related
sectors. We also detail our top picks and stocks to avoid in this report.

Contents page
Executive summary 3
— 2009 fundamentals and catalysts .........................................................................4
— Index target..........................................................................................................6
— Sector perspectives and stock picks.....................................................................6
A liquidity-driven rally 8
— Higher risk appetite ..............................................................................................8
— Increasing China weighting in EM indices ..........................................................10
Mixed economic fundamentals 12
— Positive: China’s commitment to growth .............................................................12
— Positive: signs of large-item sales recovery........................................................13
— Negative: weak external demand .......................................................................14
— Negative: overcapacity concerns........................................................................16
Earnings momentum turnaround 18
— Consensus forecasts have stabilised .................................................................18
— Lower downside risks across sectors .................................................................20
— Concern: no confirmation yet from reported numbers.........................................22
Valuations do not look cheap 23
11% MSCI China Index upside potential for 2009 25
— Bottom-up ..........................................................................................................25
— Historical trading range ......................................................................................26
— Dividend discount model (DDM).........................................................................27
— P/BV versus ROE-COE regression ....................................................................28
— Aggregate valuation measure (AVM)..................................................................29
Sector perspective and stock picks 30
— Cross-sector valuation and momentum metrics..................................................30
— Overweight sectors ............................................................................................32
— Underweight sectors ..........................................................................................35
— Our stock picks ..................................................................................................36
Company page 47
— Bank of China ....................................................................................................48
— PetroChina.........................................................................................................50
— China Shenhua Energy ......................................................................................51
— Denway Motors ..................................................................................................54
— Parkson Retail....................................................................................................57
— Anhui Conch Cement .........................................................................................60
— Beijing Enterprises Holdings...............................................................................63
— Sohu.com Inc. ....................................................................................................66
— Mindray ..............................................................................................................69
— Datang International Power ................................................................................72
— Air China............................................................................................................75
— Beijing Airport.....................................................................................................78
— Angang Steel .....................................................................................................81
— China Mobile (HK) Ltd........................................................................................84

Executive summary
Momentum often runs ahead of fundamentals, and in 2009, we believe
investors will have to cope with this more than ever before. In our view,
liquidity is the primary reason behind the index rally since March, and we
expect it to remain one of the most important market drivers for the rest of this
year. We believe rising global investor risk appetite, strong fund flows to
emerging markets (EM) and China, and more government pro-growth policies
around the world will keep fueling the momentum to China equities.
We believe important seeds for the next big bull market have been planted.
Most importantly, we expect a mid-term low-interest environment, which should
make equity investment more attractive than before. Also, there is an
unparalleled pipeline of newly started government projects, which will boost
construction demand for years. Hence, China抯 problem is not structural梑anks
are still solid and healthy梐nd the nation抯 personal wealth growth still favours
property developers and consumer product suppliers. Deregulation and
industrial reform could boost growth in key sectors such as oil and gas. Even
China抯 deep cyclical and export-oriented sectors, which have suffered severe
overcapacity and sales decline, may recover quickly once the situation in
developed countries starts to improve.
In summary, the current economic woes will eventually be over. When this
happens, we believe the unparalleled liquidity and improving fundamentals
could drive China equities to another multi-year high.
Currently, it may be a little too early to position for the next bull market.
We do not advise investors to fully load portfolios and stick to a 慴uy and hold?
strategy from now. There are still serious structural risks in the global economy.
For China, the key issue is lukewarm external demand, and a lack of private
investment pickup due to concern on widespread overcapacity.
For the rest of 2009, investors should still be mindful of a possibly
significant index retreat when valuations become stretched. Valuations on
Chinese equities are not cheap, even though consensus earnings momentum has
stabilised. Excluding the big bull rallies in 1997, 2000 and 2007, the MSCI
China Index has traded in a forward PE range of 10-17x, and a forward P/BV
range of 1.4-2.4x. Currently, there is only 10-15% upside to the historical upper
band of the 憂ormal?trading range.
In 2009, we argue that the most important thing is not what the next positive or
negative catalysts will be, but when the market will react to positive news, and
when it will react to negative news. The overall momentum is trending up. That
said, we expect that when the index gets closer to the upper band of its normal
historical range, the market will become more nervous, and negative news may
have an increasingly greater impact than positive news. After all, some factors
necessary for another bull market are still missing.
We believe the following three conditions must be satisfied before China
indices can break through their historical upper bands:
.. A recovery of external demand, which implies a sustainable improvement
in the economies of developed countries and consumption power;