Asia: Redefining Defensive China Stocks

Inflation and other pressures on the Chinese consumer could lead to re-evaluations of risks in this emerging-market's stocks.
By Daniel M. Harrison ,

Holding a vested interest in the world's fastest-growing economy has clear advantages and disadvantages, and in the coming week investors in traditionally defensive Chinese plays may see more of the latter than they have been accustomed to in recent weeks.

While the U.S. markets are exporting gains to the Nikkei and specific Chinese consumption-related equities, China's Shanghai Composite Index is dropping like a stone. In the just-ended week, the

Dow Jones Industrial Average

gained 4.4%, while the Nikkei rose directly in line with the stateside benchmark, rising 4.3%. The Hang Seng fell 1.9%, snapping a three-week wining streak, but the index's largest component,

China Mobile

(CHL) - Get Report

, surged 4.4%.

The Shanghai Composite makes for the most eye-opening reading of all, having plunged 6.1%. Loosely translated, Hong Kong has some catching up to do on the way down.

"The Hang Seng's range is getting tighter, at 23,700 to 25,000," says Steven Wong, a trader at Daiwa Securities SMB in Hong Kong. "Volumes are still only average, at HK$70 billion

$9 billion a day. Selling blocks on Thursday are still showing investor eagerness to offload, given the opportunity."

While economic data from China this week showed that retail sales are rising at a healthy pace, inflation is still far from under control at 8.3% for March. That may translate into unaccounted-for pressure on earnings going forward, analysts say.

"China's inflation risk could give way to growth risk within months," writes Hong Kong-based Citigroup economist Yiping Huang in a research note. "The first-quarter GDP data, which slowed to 10.6%, from 11.2% in the previous quarter, offers the first piece of evidence of such downside risk."

The Chinese Consumer, and China Mobile

"Earnings risk is rising," says Tim Rocks, chief Asia strategist at Macquarie Bank in Hong Kong. "While concerns about financial system failure are easing and creating a better investing environment, fears about a deteriorating earnings environment will only grow."

With surging commodity prices and sharp gains in a few key stocks whose earnings are derived from Chinese consumption growth, this may lead to a short-term reevaluation in the concept of defensive stock plays. Telecom stocks are traditionally considered defensive by investors, because of their apparent resilience to external market factors such as subprime-mortgage defaults.

Such gospel has propelled Chinese telco leader China Mobile into a bubble-like orbit vs. key listings in other sectors. In the past month, China Mobile has soared 27% vs. gains of just 6.7% in

PetroChina

(PTR) - Get Report

and 7.4% in

HSBC Holdings

(HBC)

, for example.

U.S.-listed Chinese Internet search engine

Baidu.com

(BIDU) - Get Report

has caught a variety of the same fever: in the last month, Baidu has soared a whopping 64.3%.

While bulls argue that the defensive stocks that feed off Chinese consumption growth were deeply undervalued at previous levels, the gains in these sector leaders outflank their rivals by any count. For example, China Mobile's performance far exceeds rivals

China Telecom

(CHA) - Get Report

,

China Unicom

(CHU) - Get Report

and

China Netcom

(CN) - Get Report

, which are all trading in negative territory for the month.

Alibaba.com

( ALBCF), another tech stock listed in Hong Kong, has lost 5.6% in the same period that Baidu has jumped.

Much of the gains in China Mobile have been the result of a pre-earnings rally, while Baidu has benefited from investors' associations of the stock with global search-engine leader

Google

(GOOG) - Get Report

. However, such thinking ignores the reality that these companies derive most of their earnings from domestic Chinese consumption -- a fact that is beginning to be taken into account in Hong Kong, after the release of Chinese data this week.

Macquarie's Rocks lists a short trade on consumption stocks as one of his top 10 trades for the week ahead, in a research note issued Friday. As a way of protecting against a potential further spike in equity prices in general, Rocks recommends buying Chinese banks, such as HSBC and

Bank of China

(BACHF)

.

"Banks are already at low valuations because these sectors have been caught up in the financial crisis, but other domestic sectors, including consumer ... are vulnerable to some rotational selling now," Rocks writes.

Traders broadly concur. Bryan Watkins, a trader at Daiwa Bank in Hong Kong, recommends selling China Mobile at current levels and picking up Korean telco

SK Telecom

(SKM) - Get Report

as a hedge. With gains of 6.3% for the month, SK Telecom is neither outperforming nor underperforming the market. Korean equities are also popular among Asian value investors, doing well when momentum stocks lose their luster.

"The Chinese consumption slowdown will impact China Mobile first, and if this does happen even in just a tiny, tiny way, the stock could gap down 5%," says Watkins. He adds that in the last two weeks, long-only value funds have been unloading shares in the Chinese telco leader.

A big dip in the price of China Mobile will most likely severely hamper the performance of the Hang Seng, since the stock constitutes around 12% of the index.

With the increasing focus on just a few Chinese consumption stocks, investors have taken their eyes off petrochemical names, which may benefit from an earnings upgrade over the summer, says Peter So, head of Hong Kong and China strategy for DBS Vickers in Hong Kong. So points out that because earnings estimates for market giants such as PetroChina are being calculated using a price of $85-a-barrel oil, analysts may be forced into upgrading first-half 2008 earnings during the summer.

No Clear Direction for Equities

Perhaps most importantly for investors in Chinese stocks this week is to bear in mind that almost nowhere can market participants agree right now on where the market is headed. While some forecast a further big decline in prices, former bears are moving toward the optimistic side.

"We can't even reach an agreement within our team about where stocks are going. We have a split camp. Half of us think we have found a bottom and the markets will trade sideways in a channel for the next 12 months. The other half is more bearish, expecting at least one other sharp drop or a series of down-waves before a bottom forms," says Gavin Parry, a director at Helmsman Global Trading in Hong Kong.

In other words, short of buying a spread of Hang Seng in the money and underwater options to capture implied volatility, for most investors the best strategy may be to do nothing at all.

Be sure to check out the Far East Portfolio at Stockpickr.com to find out which Indian and Chinese companies are making big moves and announcing major news.

View the embedded media.
View the embedded media.

Daniel M. Harrison is a business journalist specialising in European and emerging markets, in particular Asia. He has an MBA from BI, Norway and a blog at

www.theglobalperspective.biz

. He lives in New York.

Loading ...