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Strategists Who Called Bottom in China Stocks Now Say Buy

China’s longest bear market since 2005 is ending as government efforts to bolster the economy spur a rally in stocks, say the strategists whose buy recommendations two years ago preceded a 34 percent gain in the Shanghai Composite Index.

While the Communist Party cut its economic expansion target in March, Morgan Stanley Huaxin Securities and Guotai Junan Securities Co. say growth is rebounding from the slowest pace since 2009 as policy makers ease lending curbs. Value Investment Principals predicts stocks that benefit most from a buoyant economy will lead gains after they tumbled during the Shanghai Composite’s 423-day bear market. The retreat ranks as the second-longest since 1990, according to Birinyi Associates Inc.

“We’re definitely going to have a major bull market ahead,” Jerry Lou, the chief strategy officer at Morgan Stanley Huaxin in Shanghai, said in an April 24 phone interview.

The Shanghai Composite has rallied 14 percent from this year’s nadir on Jan. 5 as reports on bank lending and manufacturing spurred investors to snap up shares trading at the cheapest levels on record, according to data compiled by Bloomberg. The gauge of mainland-listed stocks restricted to local investors and qualified foreign institutional money managers is still 61 percent below its 2007 peak after closing at 2,396.32 on April 27. The index rose 1.8 percent to 2,438.44 at the close today.

Rally Forecasts

Lou, who advised buying stocks five days before the Shanghai Composite’s last bear market ended on July 5, 2010, says the index may rally another 30 percent this year as lower reserve requirements boost bank shares. The gauge may hit 2,800 by the end of the second quarter, Shi Weixiang, a strategist at Guotai Junan, said in an April 24 phone interview. The brokerage predicted as early as March 2010 that stocks would bottom around July of that year.

Sandy Mehta, the chief executive officer of Value Investment Principals in Hong Kong, said he favors property companies, automakers and commodity producers. Mehta forecast the second-half rally in 2010.

“Sectors that will do best have been laggards, where investors are most bearish,” he said in an e-mailed response to questions on April 24.

Optimists are placing too much faith in the ability of Chinese policy makers to cushion the world’s second-biggest economy from slumps in investment and real estate, the largest drivers of growth, Albert Edwards, a London-based strategist at Societe Generale SA, wrote in an April 19 report. Edwards warned that the 1990s boom in Asian economies was unsustainable before a financial crisis engulfed the countries in 1997.

Wen’s Target

Growth in China’s fixed-asset investment slowed to 20.9 percent in the first quarter, the weakest pace since December 2002, while home prices fell in a record 37 of 70 cities tracked by the government. Fixed-asset investment accounts for about 54 percent of China’s economy while housing construction comprises at least 10 percent, according to estimates by the Central Intelligence Agency World Factbook and Credit Suisse Group AG.

China’s gross domestic product increased at an 8.1 percent annual rate in the first quarter, down from 9.7 percent a year earlier. Average profit growth at companies in the Shanghai Composite slowed to 6.1 percent from 40 percent during the same period, data compiled by Bloomberg show.

Premier Wen Jiabao, who is trying to cut China’s reliance on exports and increase consumption, said on March 5 that policy makers have reduced their growth target to 7.5 percent from the 8 percent goal in place since 2005.

Slowing BRICs

Longer-term growth rates in China, as well as in Brazil, Russia and India, are poised to drop as their working-age populations increase more slowly before shrinking, according to a December report by Goldman Sachs Group Inc., which coined the BRIC moniker in 2001 to describe the four biggest emerging economies.

“The growth model is facing a bottleneck,” Gou Kaihong, a fund manager who helps oversee about 5 billion yuan ($795 million) at Lombarda China Fund Management Co., said in a phone interview on April 23. Gou’s Lombarda China New Momentum fund has returned 17 percent this year, according to data compiled by Bloomberg.

The economy may already be accelerating as the government pares back restrictions on lending and investment, according to Mehta, the CEO of Value Investment Principals, an investment advisory company.

Lending Surge

New loans by Chinese banks surged 49 percent from a year earlier to 1.01 trillion yuan in March, central bank data showed on April 12. Industrial production increased 11.9 percent from a year earlier, exceeding the median economist forecast in a Bloomberg survey. Reports on manufacturing, retail sales and money supply in March also topped projections.

Better-than-estimated economic reports fueled the 2010 rally in Chinese stocks even as policy makers were tightening lending restrictions and clamping down on real estate speculation to avert credit-fueled asset bubbles. Now, the government is loosening monetary policy.

Wen, who along with President Hu Jintao will hand power to a younger generation of leaders in a once-a-decade transition this year, said on April 3 that policy makers should announce “fine-tuning” measures for the economy, according to a statement posted on the government’s website. The nation will post a “steady and robust” expansion, he told reporters in Stockholm on April 24.

Reserve Ratios

China’s central bank will probably cut lenders’ reserve requirements this month following a 0.5 percentage-point reduction to 20.5 percent in February, said Morgan Stanley’s Lou. The ratio is still five percentage points above its level in 2009, according to data compiled by Bloomberg.

“I am very bullish on banks and extremely bullish on brokerages,” Lou said.

Chinese stocks are undervalued after slower economic growth spurred “excess pessimism,” according to Mehta at Value Investment Principals. New stock account openings tracked by China Securities Depository and Clearing Corp. fell to 36,678 in the week ended April 6, the fewest since Bloomberg began compiling the data in 2007. Investors opened about 566,000 accounts at the peak of the last bull market in November 2010.

The 30-day average trading volume of shares in the Shanghai Composite dropped to the lowest level since October 2008 on Jan. 4 and turnover was about 11 percent below the three-year average as of April 27, according to data compiled by Bloomberg.

China’s stock exchanges will lower fees charged for trading yuan-denominated shares by 25 percent starting June 1, the nation’s securities regulator said in an April 30 statement on its website. The regulator also released new rules for initial public offerings, saying the changes should make the price of shares “more reasonable” and improve disclosure.

Lower Valuations

The Shanghai Composite’s price-to-earnings ratio dropped to 11.4 on Dec. 27, a record-low, and the multiple was 12.7 at the end of last week, according to data compiled by Bloomberg. That’s about 60 percent below the average level of 33 since 1997. The gauge is trading at a 12 percent discount versus the MSCI All-Country World Index, compared with an average premium of 55 percent, the data show.

The China index’s bear market, defined as a drop of at least 20 percent from a recent peak, has lasted more than three times longer than the 129-day mean retreat during 26 market cycles since 1990, according to Birinyi Associates, the Westport, Connecticut-based research and money management firm founded by Laszlo Birinyi.

“We are positive on the market this year,” Wang Hanfeng, a strategist at Goldman Sachs Gao Hua Securities Co., said in an April 20 interview. Wang said the Shanghai Composite may rally to 2,900 by December.

Goldman Picks

Goldman Sachs, the most accurate brokerage for mainland-listed equities in a Bloomberg ranking of stock recommendations, has the equivalent of buy ratings on shares of China Citic Bank Corp. and Poly Real Estate Group Co.

China Citic, the Beijing-based banking unit of the nation’s largest investment company, may rally another 24 percent in the next 12 months after gaining 12 percent so far this year, according to Goldman Sachs’s share-price estimate on Bloomberg. The company is valued at 6.4 times reported earnings, down from 9.9 times a year ago, according to data compiled by Bloomberg.

Poly Real Estate, the second-biggest Chinese developer, may advance 28 percent, according to Goldman Sachs’s projection on Bloomberg. The Guangzhou-based company’s price-to-earnings ratio has declined to 12 from an average of 29 during the past five years, data compiled by Bloomberg show.

Earnings at companies in the Shanghai Composite will probably increase 31 percent during the next 12 months, compared with 22 percent in the MSCI All-Country World index and 9.4 percent for the MSCI BRIC Index, according to analysts’ estimates compiled by Bloomberg.

“Low valuations, policy loosening and falling capital costs are favorable for equities and we’ll see continuing valuation expansion,” said Shi, the Shanghai-based strategist at Guotai Junan. “We are in a bull market.”

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