Playing China’s Olympics Rebound

08/05/2008 12:00 am EST

Focus: GLOBAL

Robert Hsu

Editor, China Strategy and Asia Edge

Robert Hsu, editor of China Strategy, says China’s beaten-down stock market is poised to rally as the Games begin in Beijing.

With China's inflation problems calming, I expect the government to revert to an increasingly pro-growth stance. Add this to [robust] economic growth and [the fact that] high-quality Chinese companies continue to grow, and I think that the "elusive Olympics rally" will likely take place in the next few weeks.

This is the rebound that we've been waiting for, and that's why I recommended a closed-end fund that gives us direct access to China's domestic market—the Morgan Stanley China A-Share Fund (NYSE: CAF).

CAF invests mainly in A-shares of Chinese companies listed on the Shanghai and Shenzhen Stock Exchanges. Though these companies have relatively higher valuations, trading at an average P/E ratio of 18x, CAF contains many highly valued companies in China's most important sectors: metals and mining (21%), commercial banks (20%), and oil & gas (14%). Its top three holdings are China Merchants Bank (9%), China Construction Bank (8%), and Wuhan Iron & Steel (7%).

Based on its top holdings, you can see that financial stocks make up a big chunk of this closed-end fund. It may seem odd considering the credit crunch in the US, but Chinese lenders—especially China Merchants Bank and China Construction Bank—are in great shape to report big earnings rises in the next couple of weeks.

Along with benefiting from the strength in China's largest banks and investing in some of the best sectors in China, CAF will allow us to profit from China's strong economic growth and the appreciating currency. I expect the steady appreciation of the yuan vs. the dollar to continue, and all of the companies that the fund invests in have assets and earnings denominated in the yuan. So far this year, the yuan has gained 7% against the US dollar.

However, it is important that you remember that the fund could be very speculative since it is a closed-end fund. Closed-end funds are thinly traded and subject to more volatility than open-end mutual funds. But despite the fund's higher valuation and the risks involved, I think the profit potential is huge. As Chinese stocks climb higher in the upcoming Olympic rally that I'm expecting, CAF will also be boosted higher.

I'm lifting the buy limit on CAF slightly to ensure that you are able to buy in before the move higher. I want you to buy CAF under $40. (It closed above $36 Monday—Editor.)  I expect shares to climb to $50 or higher in the next three to six months.

Remember: Because of the speculative nature of this trade, don't invest more than 5% of your portfolio in CAF. And since it carries more risk than our other holdings, I'll be watching the fund very closely. At the first sign momentum is breaking down, we'll need to exit the trade quickly.

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