ICBC = I Can Buy Chinese (But Carefully!)

At the 12th Asia Securities Forum in Cebu, Philippines in March this year, I gave a presentation on the HK Securities Market which covered the listing of Chinese companies. At that time, I out up a slide that says ICBC (not Industrial and Commercial Bank of China but I Can Buy Chinese) as my prediction of where the market was going.

Since then of course, the HSI has hit a historical high of 30,400 moving up in leaps and bounds but still lagging the Shanghai market. Let there be no misunderatnding. HK is the proxy market for China. The Shanghai and Shenzhen markets are closed to foreigners except through QFII (Qualified Foreing Institutional Investors programme) which has a tiny US$10 billion quota shared by 50 institutions (the recent turnover in HK is between US$15-20 billion per day with a historical high of US$25 billion).

If you buy the China Story then you have to buy in HK. About 60% of the market value and 75% of the daily turnover are in Chinese stocks. The Gulf States' national budgets were based on US$35 per barrel. Now that oil is US$85, where is all that excess cash going? Certainly not to the US. Of the BRIC countries (Brazil, Russia, India, China) China has the most compelling story and the most advanced market through it's proxy in HK. When I visited ADIA (Abu Dhabi Investment Authority, the earliest and biggest Middle Eastern government investment fund) early this year, I was surprised to see Chinese nationals sitting across the table. They were hired by ADIA out of the China to research Chinese stocks.

Having said all that, I am always asked what companies to buy. My answer has always been the Chinese financials. Don't get me wrong, they are probably not the hottest thing around but in my mind they are the safest. What other in dustry has regulators sitting on top to ensure that things do not go badly wrong?

I cannot say the same for Chinese resource companies.

Recently, Chinese resource companies have been bid sky high. I am not convinced that they are worth the valuations. The market is huge, that much I agree. But resource companies are valued on the basis of their reserves and the price of their products. On the basis of reserves, the Chinese resource comapnies are valued at double their western counterparts. Do we expect their existing reserves or the prices to suddenly double?

Warren Buffett recently sold Berkshire Hathaway's 1.3% stake in PetroChina (#00857), China's largest oil company (an the largest company in China on market value). At about US$440 billion, it is the world's No. 2 company based on market value, behind ExxonMobil's $508 billion valuation. PetroChina trades for more than 20 times estimated 2007 profits, or twice its historic price/earnings multiple (Exxon's P/E is 13x and other Western oil companies such as Chevron and ConocoPhillips trade at around 10x). Berkshire bought its stake four years ago for less than US$500 million, and may have made as much as US$4 billion on the sale.

Although huge valuation gaps between Chinese and U.S. companies exist outside the resource sector, I am more relaxed because the pebetration of financial products is miniscule. China Life Insurance (LFC) has a market value of $245 billion, five times that of MetLife or Prudential Financial.

However, we cannot apply the same arguments to resource companies in China because oil and coal are fungible international commodities. Also, it is difficult for Chinese resource companies to buyout Western resource companies because of politics. US Congressional opposition frustrated an attempted takeover of Unocal by China's state-owned oil company in 2005; Unocal later was sold to Chevron.

The key to high stock-market values in China is that ordinary Chinese investors have little choice because of capital restrictions on investing overseas and the scarcity value created by the thin floats in many big Chinese companies. PetroChina, now 88%-owned by the Chinese government, will sell Chinese investors US$9 billion of Class A shares to be listed on the Shanghai Stock Exchange. But the government's stake will slip only to 86%. Until now, PetroChina's shares have traded only in Hong Kong and as ADRs on the New York Stock Exchange. If all the company's shares were freely held, PetroChina would not command such a high valuation.

Since Chinese investors cannot buy Western stocks, comparison between PetroChina and Exxon is only useful for Western investors who can buy both. PetroChina is listed in HK and trades at more reasonable value precisely because HK is an open market with no capital or investors restrictions.

The only thing going for PetroChina is that its profits are depressed by price controls in the Chinese market for gasoline, other oil products and natural gas. The company gets about $3 per thousand cubic feet of natural gas, half of what Exxon nets. The gradual lifting of price controls in China will boost PetroChina's refining and natural-gas profits but prices will have to double before PetroChina and Exxon trades at similar PE's.

St. Louis-based Peabody Energy, the world's largest private-sector coal producer, trades at 30 times earnings while China Shenhua trades at 60x. China's largest coal company, China Shenhua Energy (#01088), is valued at $200 billion. When China Shenhua was listed in Shanghai earlier this month, its share price doubled in value. It since has risen to RMB 77 per share. China Shenhua, which already was listed in Hong Kong, now has a market value of about $190 billion, more than 10 times Peabody's value. Yet its annual production and reserves are less than Peabody's. But China Shenhua gets far higher prices for its coal than Peabody, and has power and railroad assets.