As China's bubble fears grow, choosy investors favor large caps

Beijing -- AS CHINA'S stock markets have zoomed to new highs this year, local investors have become increasingly worried about a bubble and are getting pickier with their choices.
The result? The market is going still higher, as investors pour cash into the large companies that dominate the broad indexes. Such stocks are seen as safe and conservative investments in the context of China's market, and are favorites of domestic mutual funds and institutional investors.

So even as concerns about a bubble grow, many analysts are still saying that China's biggest listed companies are worth buying, since they are generally seen as well positioned to deliver decent earnings growth at a lower risk. These tend to be state-controlled companies in sectors from energy to telecommunications to metals and real estate.

The shares, traded in Shanghai and Shenzhen, are generally off-limits to foreign investors, although shares of some companies also trade in Hong Kong. Also, foreign fund managers who get licensed as Qualified Foreign Institutional Investors can buy into the mainland's own stock market. "We suggest investors still focus on large-cap blue-chip companies, as they turn out faster revenue growth than others, and they can gain more strength by expanding to overseas markets," says Cheng Weiqing, chief strategist with Citic Securities Co. in Beijing.

Blue-chip stocks have become the biggest driver of the recent rally. Since hitting its recent low on July 6, the broad Shanghai composite index has surged 57%. But the Shanghai Stock Exchange 50 Index, which measures the performances of 50 large-capitalization companies, has done even better, rising 64%. The Shenzhen Stock Exchange's index for small and midsize companies has gained 23% during the same period. Overall, the Shanghai composite index has risen 109% this year, while the Shenzhen counterpart has gained 150%.

Some of the market's 10 largest stocks by market capitalization have done even better. At a peak on Oct. 15, shares of Aluminum Corporation of China, also known as Chalco, were more than triple their close on their first day of Shanghai trading, in April. Shares of China Cosco Holdings are 3 1/2 times their first day close, on June 26, of 16.38 yuan.

As the market's gains become focused in a smaller group of big companies, some once-popular stocks are starting to stumble. Beijing Urban Construction Investment & Development, once a hot pick for investors looking for a play on the 2008 Olympics, has lost 30% compared with its peak in June. Zhejiang China Commodities City Group, a wholesale marketer for industrial goods, has dropped 37%.

That's one reason Yang Liu, an analyst at China Chengxin International Credit Rating, is advising a more defensive strategy. He favors companies he says can post stronger earnings when the economy is good, while also holding up well during a recession. Among those meeting the criteria, he says, are real-estate developer China Vanke, coal miner China Shenhua Energy and financial institutions China Merchants Bank and China Construction Bank.

While the surge in China's inflation this year increases the risk that the central bank will keep raising interest rates, potentially denting stock prices, Citic's Mr. Cheng says investors can benefit from rising prices by buying energy and other natural-resource stocks. Mr. Cheng likes China Petroleum & Chemical, the refiner better known as Sinopec, and PetroChina, China's largest oil supplier. While some analysts think Sinopec is overvalued, Mr. Cheng thinks the stock -- among the biggest on the Shanghai exchange by market cap -- is Shanghai's most attractively valued blue chip. PetroChina is in the process of a giant share sale to add a Shanghai listing to the one it already has in Hong Kong.

For those worried that the market has risen more than the fundamentals justify and is likely to experience a big decline, the most-conservative strategy is to stay on the sidelines. Jiang Zuoliang, director of the investment department for E Fund Management, says his team largely hasn't bought anything in the past two months. "We are waiting for a correction," he said.
But such views are the exception. Indeed, stocks and mutual funds are so popular in part because other investment options offer such poor returns. Chinese government bonds and bank deposits pay fairly low interest rates, currently just over 3%, which doesn't keep up with an inflation rate expected to surpass 4% for this year.

So domestic mutual funds are raising money and launching at a fast pace. According to research by Beijing-based TX Investment Consulting, new mutual funds have raised 417.7 billion yuan ($55.78 billion) from investors so far this year. In 2006, mutual funds raised 393.5 billion yuan.
Many strategists and analysts are happy to concede that the stock market is in a bubble. But they think it isn't going to pop anytime soon and aim to profit from further rises.

"There's definitely a bubble, but it's not yet the time for it to burst," says Lin Wenjun, strategist with Fullgoal Fund Management. She says she believes the outlook for the economy remains positive, and there is plenty of investor cash available to push stock prices higher.

-- Zhou Yang