China-HK Chronicles (%) Source: DataStream, Credit Suisse estimates

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1 7 August 214 Asia Pacific/China&Hong Kong Equity Research Strategy Research Analysts Vincent Chan Bin Wang Victor Wang Trina Chen Kevin Yin Iris Wang Kenneth Fong Arjan van Veen Frances Feng Dick Wei Edmond Huang, CFA Horace Tse Jinsong Du Colin McCallum, CA Dave Dai, CFA China-HK Chronicles STRATEGY August 214: Alternative investment universe and discount rate Figure 1: More balanced "New" and "Old" economy in "China Plus" (%) "China Plus" MSCI China H Share Consumer Info Tech Health Care Energy & Materials Industrials Financials Real Estate Telecom & Utilties Source: DataStream, Credit Suisse estimates Investors perceive that China will underperform other markets. The reality is that the underperformance of China's market is largely concentrated in the old economy H shares listed in HK. An alternative China investment universe. We have created a new index called "China Plus" index which consists of MSCI International China, Macau and some A shares. This index is up 8% from end-28 and its performance is not bad even compared with the developed market indices. The current weighting of A shares is rather small, but we believe the "Shanghai-HK Connect" scheme will boost the weighting. Discount rate for China stocks. We have calculated the Implied Equity Risk Premium for China and Hong Kong markets, based on both the RMB and HKD rates as risk-free rates for China stocks in HK. Despite the current divergence of risk-free rate and equity risk premium for China / HK markets, over time the "Shanghai-HK Connect" scheme will likely bring both the riskfree rate and equity risk premium of the two markets closer to each other. Switch from Baosteel to Angang and increase weighting of AIA and China Unicom. We switch from Baosteel to Angang in the Credit Suisse China Model Portfolio and retain the weighting unchanged. In the China / Hong Kong model portfolio, we reduce the weighting of HSBC, Henderson Land and increase the weighting of AIA and China Unicom. DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION Client-Driven Solutions, Insights, and Access

2 7 August 214 Focus table and charts Figure 2: "China Plus" Index vs. Developed World Indices 2 Dec'8 = Dec-8 Dec-9 Dec-1 Dec-11 Dec-12 Dec-13 "China Plus" Index S&P Euro Stoxx FTSE 1 Source: DataStream Figure 4: Risk-free rate of China and HK 6 1-Yr Govt Bond Yield Jan-3 Dec-4 Nov-6 Oct-8 Sep-1 Aug-12 China HK Figure 3: Implied Discount Rate (EDR) of various indices 12 Implied Discount Rate (%) Jan-3 Dec-4 Nov-6 Oct-8 Sep-1 Aug-12 MSCI China Shanghai A CSI 3 MSCI HK Source: DataStream, Credit Suisse estimates Figure : Equity risk premium MSCI China & Shanghai A 1 (%) Jan-3 Dec-4 Nov-6 Oct-8 Sep-1 Aug-12 MSCI China IDR vs. HK 1Y Bond Shanghai A IDR vs. CN 1Y Bond Source: DataStream, Credit Suisse estimates Figure 6: Sector weighting of "China Plus" vs Other China indices Sector weighting (%) "China Plus" Index MSCI China MSCI Int'l China H Share Consumer discretionary Consumer staples Energy Financials Banks Insurance Diversified financials Real estate Healthcare Industrials Capital goods Transport Information technology Materials Telecom services Utilities Total Broad consumer sector* * Including consumer discretionary, consumer staples, healthcare & IT. Source: DataStream China-HK Chronicles 2

3 7 August 214 An alternative China investment universe Investment professionals usually use MSCI China and H-share as key benchmarks of the China investment universe, and the general conclusion is that it has been underperforming other markets by a wide margin, but is this really the case? The reality is that the underperformance of China is largely concentrated in the old economy H shares listed in HK. This is the reason why MSCI China has actually outperformed HSCEI (H share index) by 21 pp from end-28 till now. If US listed Internet stocks, Macau names and some A shares are included, the performance of this "alternative" universe actually is rather good, only underperforming S&P by a small margin but outperforming European stocks (using Euro Stoxx as proxy) by a wide margin. To start with, it would be useful to introduce a not-so-well-known MSCI index called MSCI International China, which includes the stocks in MSCI China plus some major China plays listed in the US, such as Baidu, Ctrip, etc. MSCI International China is the aggregated index of MSCI China and MSCI Overseas China (all of them are US and Singapore listed China plays). From end-28 till now, this index outperformed MSCI China by 14 pp. Given that many investors have included Macau stocks as part of their China portfolio exposure, as well as some A shares through the QFII, we have created a new index comprising MSCI International China as well as these two groups of stocks. For Macau stocks, we take those which are already in MSCI HK and include their MSCI adjusted market cap into MSCI International China. For A shares, we have chosen the 2 largest market cap A shares with no H share listing, and attribute a % weighting on their market cap to include into MSCI International China. The low weighting for A shares reflects that currently, based solely on the QFII scheme, it is still difficult for foreign investors to participate in the A share market, but we expect the situation could change over time with the "Shanghai-HK connect" scheme. Figure 7: A shares and Macau stocks included in "China Plus" index Name of stocks A shares Macau stocks Source: Credit Suisse Kweichow Moutai, Industrial Bank, SAIC Motor, Shanghai Pudong Development Bank, Ping An Bank, China Yangtze Power, Daqin Railway, Shanghai International Port, China State Construction, GREE Electric, China Shipbuilding Industry Corp, Midea Group, BOE Technology, Henan Shanghui, Wuliangye Yibin, Inner Mongolia Yili, Bank of Beijing, China United Network, Huaxia Bank, Baoshan Iron & Steel MGM China, Sands China, Wynn Macau Between end-28 till now, this index (we called it China Plus Index below) was up 8%, outperforming both MSCI China (18% points) and H Share (39% points) significantly. Underperformance of China market is largely concentrated in the old economy We created a new index comprising MSCI International China Index, Macau stocks and a few A share stocks and we call it "China Plus" index The index was up 8% from end-28 China-HK Chronicles 3

4 7 August 214 Figure 8: "China Plus" index vs other China indices 2 Dec'8 = Jun-14 Dec-13 Jun-13 Dec-12 Jun-12 Dec-11 Jun-11 Dec-1 Jun-1 Dec-9 Jun-9 Dec-8 MSCI China Int'l "China Plus" Index MSCI China H Share Source: DataStream Compared to the developed world market, the performance of this index was not very bad. Up till the end of 212, the performance of China Plus Index was roughly at par with S&P ; it is only in the last one-and-a-half years that the China Plus Index underperformed. Compared to Eurozone stocks (using Euro Stoxx as proxy) and FTSE 1, China Plus Index actually outperformed by 36 pp and 28 pp respectively during this five-and-a-half year period. The "China Plus" index performance was also not very bad versus developed world market Figure 9: "China Plus" index vs developed world indices 2 Dec'8 = Jun-14 Dec-13 Jun-13 Dec-12 Jun-12 Dec-11 Jun-11 Dec-1 Jun-1 Dec-9 Jun-9 Dec-8 "China Plus" Index S&P Euro Stoxx FTSE 1 Source: DataStream Composition of "China Plus" The weighting of the four components of "China Plus" Index, i.e., MSCI China, MSCI Overseas China, Macau gaming stocks and selected A shares are shown in the figure below. MSCI China still accounted for about 8% of the index. Weighting of the four components of "China Plus" index China-HK Chronicles 4

5 7 August 214 Figure 1: Composition of the "China Plus" index MSCI Overseas China 1% Macau gaming stocks 3% A Shares 2% MSCI China 8% Source: DataStream In terms of sector allocation, "China Plus" is also very different from MSCI China and HSCEI, with a smaller share of financials (banks) and much bigger share of IT (mostly Internet stocks), consumer discretionary (Macau gaming stocks) and consumer staples. Therefore, the "China Plus" index benefited from the massive re-rating of the "new economy" sectors in the last few years, while the H-share index was saddled with the underperforming "old economy" sectors such as banks and energy. Sector allocation of "China Plus" index Figure 11: Sector weighting of "China Plus" vs other China indices Sector weighting (%) "China Plus" index MSCI China MSCI Int'l China H share Consumer discretionary Consumer staples Energy Financials Banks Insurance Diversified financials Real estate Healthcare Industrials Capital goods Transport Information technology Materials Telecom services Utilities Total Broad consumer sector* * Including consumer discretionary, consumer staples, healthcare & IT. Source: DataStream The top ten stocks of "China Plus" are actually very similar to MSCI China, with the only exception being that one of China's major US listed Internet companies, Baidu, was there but not in MSCI China. However, the composition of the key stocks in the H-share index is very different from the others. Top ten stocks of "China Plus" index China-HK Chronicles

6 7 August 214 Figure 12: Top 1 stocks of "China Plus" and other Indices "China Plus" index MSCI China MSCI Int' China H-share Tencent Tencent Tencent ICBC China Mobile China Mobile China Mobile China Construction Bank Baidu China Construction Bank Baidu Bank of China Ltd China Construction Bank ICBC China Construction Bank Bank of China ICBC Bank of China ICBC Sinopec Bank of China CNOOC Bank of China China Life CNOOC PetroChina CNOOC Ping An PetroChina Sinopec PetroChina Agricultural Bank of China Sinopec China Life Sinopec China Shenhua Energy China Life Ping An China Life China Merchants Bank % of total weighting % of total weighting % of total weighting % of total weighting Source: MSCI, Credit Suisse research China-HK Chronicles 6

7 7 August 214 Discount rate for China stocks In this note, we examine the proper discount rates for China stocks, both A and H share. The standard equation for the discount rate of a security (i) should be: R = W D x R f + W E x R i ; while W D is the weighting of debt in the capital structure of the stock, W E the weighting of equity in the capital structure, R f is the risk-free rate and R i is the expected return of security i, and: R i = R f + β i x E r, while E r is Equity Risk Premium and βi (beta) is the sensitivity of security versus the market. The focus on this note is on R f and E r, as W D and W E should be determined on an individual stock basis and βi is largely a statistical measure which can be calculated from stock price movements versus the market. However, we consider that there are many stocks listed in either (or both) HK and mainland markets, with very different risk-free rates and equity risk premium. Risk-free rate (R f ) For China A shares, R f is easy to determine, as it should be the long-term government bond yield, and the ten-year Chinese government Rmb denominated bond is a good indicator to choose. For the China stocks listed in HK, R f would be more difficult to decide. Given the assets and business operations of China, there is a strong case to argue that Chinese long bond rate should be used as risk-free rate for Chinese stocks listed in HK. However, at the same time, since these Chinese stocks are traded in HK and the share price is denominated in HKD, it is also fair to argue that HKD long bond rate should be its risk-free rate. We examine the proper discount rates for China stocks Risk-free rate for China stocks listed in HK Figure 13: Ten-year government bond yield for China and HK 6 1-Yr Govt Bond Yield Jan-3 Feb-4 Mar- Apr-6 May-7 Jun-8 Jul-9 Aug-1 Sep-11 Oct-12 Nov-13 China HK Before the US financial crisis in late 28, the difference between the Rmb and HKD long bond rate was not much. However, the gap widened significantly afterwards, with the major reason being that the HKD interest rate dropped following the USD QE operations, while the Rmb interest rate remained stable. From 4Q8 onwards, the average 1Y Rmb bond yield was 3.7% (similar to average of 3.8% between Jan-3 and Sep-8), but 1Y HKD yield was only 1.9% (down from 4.% between Jan-3 and Sep-8). Therefore, The gap between Rmb and HKD long bond rate widened after 4Q8 China-HK Chronicles 7

8 7 August 214 whilst before 28 it was just a theoretical problem to debate what the proper risk-free rate for Chinese stocks was in HK, after 28 the implication is very real. Implied discount rate and equity risk premium Given that there is theoretical support for using HKD and Rmb long bond yield as risk-free rates for Chinese stocks in HK, it is probably worthwhile to check the verdict of the market. Here, we could use a Dividend Discount Model (DDM), assuming that the share price revealed in the market is the fair value of the stocks; then, based on some forecasts of long-term EPS growth and dividend payout ratio, we can calculate the Implied Discount Rate (IDR) of various market indices. Figure 14: DDM model assumptions on China / Hong Kong market EPS growth rate (%) Payout ratio (%) Mid-term Long -term Yr1-3 Mid-term Terminal MSCI CN CSI SH A MSCI HK 4 4 Source: Credit Suisse estimates In recent years, IDR for all key China indices, including MSCI China, Shanghai A share and CSI 3, are not much different from each other, irrespective of whether they are listed in HK or the mainland. But the IDR for all the China indices are significantly higher than Hong Kong stocks in MSCI HK. This seems to imply that investors are placing a lower risk premium on HK stocks compared to China stocks. We calculate the IDR of various market indices IDR for China indices are significantly higher than Hong Kong stocks Figure 1: IDR of various stock market indices 12 Implied Discount Rate (%) Jan-3 Mar-4 May- Jul-6 Sep-7 Nov-8 Jan-1 Mar-11 May-12 Jul-13 MSCI China Shanghai A CSI 3 MSCI HK Source: DataStream, Credit Suisse estimates. For the market as a whole, IDR should be equal to risk-free rate (R f ) + implied equity risk premium (IE R ), as the β of the whole market would always be equal to 1. Therefore, with the IDR data, we would be able to calculate IE r. For the IE r of MSCI HK, Shanghai A and CSI 3, the calculation is rather easy, as their risk-free rates are well-defined. The problem is for MSCI China, as the proper risk-free rate for it is debatable. We use IDR to calculate IE R. China-HK Chronicles 8

9 7 August 214 (A) If Rmb rate used as risk-free rate for China stocks listed overseas then the implied equity risk premium (IE R ) of MSCI China will be very similar to the A- share market from 211 onwards. Indeed, in this scenario, we are actually saying that there is effectively no difference in the risk appetite for foreign and mainland investors on China stocks. No difference in the risk appetite for foreign and mainland investors on China stocks Figure 16: IE R of MSCI China and Shanghai A based on RMB risk-free rate Jan-3 Mar-4 May- Jul-6 Sep-7 Nov-8 Jan-1 Mar-11 May-12 Jul-13 MSCI China IDR vs. CN 1Y Bond Shanghai A IDR vs. CN 1Y Bond Source: DataStream, CEIC However, by the same token, the IE R of MSCI China would be even lower than that of MSCI HK throughout the years. This does not make too much sense based on our discussion with overseas investors, who generally believe that the HK companies, while they may not have growth momentum as strong as Chinese stocks, are generally believed to be operating in a more transparent and "safe" environment with well-established business practices. Therefore, it would be difficult to agree to the conclusion that the equity risk premium of China stocks are lower than HK stocks. Figure 17: IE R premium of MSCI China and MSCI HK assuming different risk-free rate Jan-3 Mar-4 May- Jul-6 Sep-7 Nov-8 Jan-1 Mar-11 May-12 Jul-13 MSCI China IDR vs. CN 1Y Bond MSCI HK IDR vs. HK 1Y Bond Source: DataStream, CEIC China-HK Chronicles 9

10 7 August 214 (B) If HKD rate used as risk-free rate for China stocks listed overseas then the IE R of MSCI China and MSCI HK were very close to each other until mid-211, when China stocks started to de-rate and IE R of China stocks started to become higher than that of HK stocks. IER of MSCI China and MSCI HK were very close until mid-211. Figure 18: IE R of MSCI China and MSCI HK assuming using HKD risk-free rate Jan-3 Mar-4 May- Jul-6 Sep-7 Nov-8 Jan-1 Mar-11 May-12 Jul-13 MSCI China IDR vs. HK 1Y Bond MSCI HK IDR vs. HK 1Y Bond Source: DataStream, CEIC Under HKD bond yield as risk-free rate for China stocks listed overseas, the IE R of A-share market has always been lower than MSCI China, i.e., mainland investors have always been more comfortable about China stocks than overseas investors. It is only because of the low HKD rate (due to US QE) that the discount rate of MSCI China is similar to Shanghai A share. Compared to 211, the gap between the IE R of the two markets has been reducing in the last 1-2 years. Gap between IE R of the two markets has been reducing in the last 1-2 years Figure 19: IE R of MSCI China and Shanghai A using different risk-free rate Jan-3 Mar-4 May- Jul-6 Sep-7 Nov-8 Jan-1 Mar-11 May-12 Jul-13 MSCI China IDR vs. HK 1Y Bond Shanghai A IDR vs. CN 1Y Bond Source: DataStream, CEIC Indeed, this probably also explains why before the global financial crisis in 28, A shares had always been much more expensive than H shares. It is only in recent years that they became closer in valuation. China-HK Chronicles 1

11 7 August 214 Figure 2: Hang Seng AH premium index 2 Hang Seng AH Premium Index (A share more expensive if >1) Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-12 Jan-13 Jan-14 Looking ahead Despite the current divergence of the risk-free rate and equity risk premium, over time the "Shanghai-HK Connect" scheme will likely bring both the risk-free rate and equity risk premium of the two markets closer to each other. Currently, risk-free rate in the A share market is higher than that of China stocks in HK, whilst the equity risk premium of China stocks in HK is higher than that of A shares. Over time, we believe the risk-free rate for China stocks in HK will move closer to the Rmb rate used in the A share market as domestic liquidity at the end would usually play a bigger role in the stock market for large and cash rich economies, while the equilibrium equity risk premium would likely be somewhere between that of A shares and China stocks in HK. So, with everything remaining unchanged (which is not likely as interest rate and equity risk premium for markets are heavily correlated with economic performance), the discount rate for China stocks trading in HK will likely edge up, while that for A shares could come down. Over time, we think the riskfree rate for China stocks in HK is moving closer to the Rmb rate used in the A share market China-HK Chronicles 11

12 7 August 214 Index target, model portfolios and top picks A summary of our 12-month index targets for major China and Hong Kong indices follows. MSCI HK would have a potential downside of 9.8%, while for HSCEI and Shanghai A, this would be an upside of 17.2% and 16.%, respectively. Figure 21: Targets for major China/HK indices Index Upside Discount EPS growth assumptions (%) Consensus EPS growth (%) Implied P/E (x) target (%) rate (%) E 21E E 21E E 21E MSCI China HSCEI 13, Shanghai A Share 2, Hang Seng Index 27, MSCI HK 13, (9.8) Source: DataStream, Credit Suisse estimates We created two model portfolios benchmarking MSCI China and Hang Seng Index separately. Credit Suisse China model portfolio We have run this model portfolio from the start of 28, benchmarking MSCI China. In more than six years, the CS China model portfolio has outperformed MSCI China by 22.1%, but underperformed the benchmark by 2.7% in 214 YTD. We make a minor change to the constituent stocks: Replace Baosteel with Angang and retain the weighting unchanged at 2%. Figure 22: Credit Suisse China model portfolio Weighting (%) CS MSCI vs MSCI Recommended stocks Consumer discretionary Belle (2%), Anta (2%), Shenzhou (2%), Guangzhou Auto(2%), Gome (2%) Consumer staples 2..2 (3.2) China Modern Dairy (2%) Energy Sinopec (12%), Shenhua (3%) Financials Banks ICBC (12%), ABC (1%), Minsheng (2%) Diversified financials Cinda (2%) Insurance China Pacific (8%) Real estate Vanke A (2%), CR Land (2%), SOHO (2%) Health care (.7) CAH (1%) Industrials. 6.2 (1.2) Capital goods (1.1) Goldwind (3%) Transportation Daqin Railway (2%) Information technology (4.4) Baidu (2%), Tencent (3%), Hollysys (2%), Aisino 2%) Materials Angang (2%), Conch (2%) Telecom services China Mobile (6%), China Unicom(%) Utilities (.9) Longyuan (3%) MSCI China Consumer sector* (3.7) * Consumer sector includes consumer discretionary, consumer staples, healthcare and IT. Source: Thomson Reuters, Credit Suisse estimates CS China model portfolio has outperformed MSCI China by 22.1% since inception China-HK Chronicles 12

13 7 August 214 Figure 23: Summary of CS China portfolio and MSCI performance Index Performance Relative performance MSCI CS CS MSCI Compounded CS-MSCI 1 Jan Dec Dec Dec Dec Dec Dec YTD Jun Since inception in Source: DataStream, Credit Suisse research Figure 24: Relative performance of CS China portfolio versus MSCI China Source: Datastream, Credit Suisse research Credit Suisse China/HK model portfolio From the inception of the CS China/HK model portfolio on 6 December 213, this has underperformed the Hang Seng Index by 3.%. The NEUTRAL weighting of China stocks in the HSI is 3.%, and in our portfolio it is 9.%, so we OVERWEIGHT China versus Hong Kong. We make a few changes to the constituent stocks: (1) Reduce the weighting of HSBC from 1% to 9% and remove Belle. (2) Increase the weighting of AIA from 6% to 7%. (3) Reduce the weighting of Henderson Land from 3% to 2%. (4) Increase the weighting of China Unicom from 3% to 4%. We OVERWEIGHT China stocks versus Hong Kong stocks China-HK Chronicles 13

14 7 August 214 Figure 2: Credit Suisse's China/HK model portfolio (benchmarking the Hang Seng Index) Weighting (%) CS Hang Seng vs HS Index Recommended stocks Consumer discretionary Sands(%), Samsonite (2%), Gome(2%) Consumer staples (1.3) China Modern Dairy(2%) Energy (.6) Sinopec (7%), Shenhua (2%) Financials Banks ICBC (11%), HSBC (9%), BOC HK (8%), ABC (6%) Diversified financials HKEX (2%), Cinda (2%) Insurance AIA (7%), China Pacific (4%) Real estate (1.4) CR Land (4%), Henderson Land (2%), Swire Prop (3%) Industrials Capital goods Hutchison (2%), Goldwind(2%) Transportation Cathay Pacific (2%) Information technology (6.9) Tencent (3%) Materials Conch (2%) Telecom services China Mobile (4%), China Unicom (4%) Utilities (1.6) Longyuan (3%) Hang Seng Index China stocks Source: Thomson Reuters, Credit Suisse estimates Figure 26: Relative performance of CS China/HK portfolio versus HSI Source: Bloomberg, Credit Suisse research China-HK Chronicles 14

15 7 August 214 Top buy and sell ideas from CS analysts Figure 27: Top picks by CS analysts Sectors Rec Name Ticker Rationale China Strategy O ICBC 1398.HK We view ICBC as a premium quality large bank. ICBC is particularly strong in three areas, namely (1) leading IT system; (2) strong operating control like cost management; and (3) conservative risk appetite. China Pacific 261.HK Strong new business momentum in life insurance (agency up 44%), remediation of P&C margins likely in 214 and a very strong capital position (materially better than peers'). Goldwind 228.HK Strong 1H14 guidance, good margins on cost control, strong backlog. China Unicom 762.HK Biggest beneficiary of the spin-off of its tower assets. Angang 347.HK A key beneficiary of improving S/D and spread in Chinese steel sector, especially its higher exposures in flat steel segment. We expect sequential improvement in unit EBITDA through 214E to drive continued Outperformance of the stock. Angang s cost cutting effort since 213 should also lead to Rmb mn additional cost saving in 214E. Current valuation is at.6x P/B, thus has not factored most of the improvement ahead. Hong Kong Strategy O HKEx 388.HK Key beneficiary of the Shanghai-HK through train scheme. Hutchison 13.HK On the verge of a large asset monetisation programme that will unlock value in its unlisted businesses, driving a material narrowing of the current 26% NAV discount. Sands China 1928.HK Sands China has the largest asset base (hotel rooms and gaming tables) which is likely to see most room for yield optimisation; the % dividend yield offers solid downside support. China Auto O GAC 2238.HK Strong new model pipeline, especially global brand SUVs. China Banks O ABC 1288.HK ABC is our top pick among large SOE banks. ABC has the lowest LDR among large peers, thanks to its leading network and dominating position in rural areas. It also has built the highest loan loss reserve, accounting for 4.% of total loans. Sufficient liquidity, decent loan loss reserve and the stronger economic growth of rural areas all suggest ABC is likely to deliver faster loan and net profit growth relative to large peers. CRCB 3618.HK CRCB is our top pick among city commercial banks. Though this bank has a very traditional business model and heavily relies on net interest income (>9% of revenue), we argue the stock is providing deep value given cheap valuation and very strong local economy in Chongqing. Further, CRCB has a leading deposit market share in Chongqing, implying it can potentially provide some upside loan growth risk if China further loosens monetary policy. CITIC 998.HK CITIC Bank remains our top pick among joint-stock commercial banks (JSCBs). Trading at.7x 214E P/B, we view CITIC as an undervalued stock with improving fundamentals. The bank has made few senior management changes in the past two years, resulting in substantial internal restructuring and business focus shift. Currently, CITIC is actively cooperating with China s leading e-commerce and Internet players, and pays high attention to lift fee income contribution. Basic Materials O CRC 1313.HK We believe cement prices in Southern China to see less downside than other coastal regions, mainly driven by continued growth in infrastructure and urbanisation. Strong margin improvement in southern provinces from 2H13. At Rmb8/t in unit gross profit, we estimate EPS is HK$.62/sh, implying 8.x P/E. Risk remains on upside. CNBM 3323.HK We believe the market will welcome any incremental effort from CNBM to meaningfully improve its capital structure as the cement market stabilises. The possibility rises now with the SOE reform. While visibility on large-scale asset restructuring remains poor, the start of the reform process should be enough to rerate the stock at this point, especially given its underperformance versus peers and low expectations. Angang 347.HK A key beneficiary of improving S/D and spread in Chinese steel sector, especially its higher exposures in flat steel segment. We expect sequential improvement in unit EBITDA through 214E to drive continued outperformance of the stock. Angang s cost cutting effort since 213 should also lead to Rmb mn additional cost saving in 214E. Current valuation is at.6x P/B, thus has not factored most of the improvement ahead. U China Coal 1898.HK Depressed coal price and high cost position will put Chinacoal in increasingly challenging operating conditions. The company s aggressive investment in coal chemical business will lead to further deterioration in balance sheet. China Brokers O Haitong 6837.HK Improving fundamentals, abundant capital and more attractive valuation. China Consumer O Mengniu 2319.HK Expanding into high-margin segments, improvement in execution; benefit from input cost easing. Gome 493.HK Turnaround based on new omni-channel strategy; evolving from a landlord to supply chain operator; narrowing loss in online biz. China-HK Chronicles 1

16 7 August 214 Figure 28: Top picks by CS analysts (continued) Sectors Rec Name Ticker Rationale China Health Care O China Animal Health 94.HK CAH is our top pick in the China healthcare sector for its attractive valuation and high growth visibility. High growth from vaccine direct sales is not fully priced in. CAH s collaboration with Elanco (Eli Lilly) is ongoing with regards to domestic sales and marketing and overseas product registration. U Sino Biopharm 1177.HK Sino Biopharm is facing intensifying competition in the drug tenders as three of its four blockbuster drugs that account for 6% of FY13 revenue are becoming non-exclusive drugs. The stock is one of the most expensive in the sector. China Industrials O Goldwind 228.HK Strong 1H14 guidance, good margins on cost control, strong backlog. CNR 6199.HK Cheap alternative to CSR, strong high-speed train order expected in 2H14. Singyes 7.HK Current valuation offers good risk-reward for the potential ramp up of solar distribution generation. Insurance O China Pacific 261.HK Strong new business momentum in life insurance (agency up 44%), remediation of P&C margins likely in 214 and very strong capital position (materially better than peers). Techtronics 669.HK Margin expansion, market share gain, strong working capital and cash flow management. Ping An 2318.HK Strong operating trends in insurance divisions and valuation appeal (life co has implied 2% discount to China Life / implied bank valuation in negative). Key issue is concerns over asset quality of bank division. U PICC Group 1339.HK Low quality life insurance franchise and weak capital position remains key issue. Exposure can be replicated better through owning PICC P&C and stand-alone life company. New China Life 1336.HK Deteriorating asset quality and business mix and weak capital position with likely nearterm capital raising (either equity or preference shares). Internet O Baidu BIDU.OQ Strong mobile monetisation momentum and likely margin leverage into 21. YY YY.OQ 2Q results and 3Q guidance will likely both beat and the education initiative is a free option for current share prices. BITA BITA.N Leader in performance-based sales digitisation in auto vertical, with meaningful margin expansion potential in the coming quarters. Macau Gaming O MGM China 2282.HK Resilient premium mass-market growth, strong management execution to defend its market share despite keen competition from Cotai and improving the table yield (and hence margin). In medium term, its capacity is set to double when MGM Cotai opens in mid-216. Valuation looks undemanding (trading at 16x 214 P/E, 1% discount to its peers) with solid % dividend yield as downside support. Oil & Gas O Sinopec 386.HK Marketing restructuring could help unlock intrinsic value of its dominant business; we expect the transaction details to be announced by end of 3Q14. China Property O Vanke 222.HK Another blue chip in the sector and a safer choice amid sector downturn. It benefits from ongoing SOE reforms. SOHO China 41.HK A pure office play in the core areas of Beijing and Shanghai only. It should outperform peers, as it has no exposure in the housing market, which has just entered a prolonged downturn. HongKong Property O HK Land HKLD.SI HKLand posted strong set of results and most striking takeaway is that only 4% of HKLand's Central office portfolio is left for expiration in 2H14. We expect a much easier 2H14 than we thought and HKLand's fundamental driver to close its gap with Swire Prop. SHKP 16.HK We expect further improvement in sentiment in HK residential market with SHKP executing its asset turnover strategy and remaining the most active developer. Telecoms O China Unicom 762.HK Continues to grow revenue market share within a growth market, and deliver both EBITDA margin expansion and high operational gearing to the bottom line. Transport O OOIL 316.HK Best cost management of APAC's liner players, over capex hump so any improvement in revenues will likely drive distributions Cathay Pacific 293.HK Freight volumes starting to grow consistently, front-end traffic robust and lead-in fare pressure on new US services should abate as these mature Utilities O CEI 27.HK CEI is well-positioned with new project wins from both public bidding and M&As driven by stricter emission standards. 214 YTD, CEI has achieved 81% of our FY14E WTE capacity projection, which is also higher than market expectations. China Gas 384.HK China Gas is offering both (1) promising near-term earnings growth (18% FY1-17 EPS CAGR) supported by strong momentum of new connections as well as new project acquisitions and (2) long-term sustainability with 19% FY14-2E volume CAGR, supported by Russian Gas. U HNP 92.HK First, evident from the strong correlation between stock prices and spot coal price, stabilisation of coal price could cap the earnings upside for IPPs. Also, following a few months of delays, we expect to see 3% tariff cut to take place in later 3Q14 or early 4Q14, which would result in lower earnings in 2H14 than 1H14. Asset injections could be a positive theme but timing is uncertain. Note: O = Outperform; N = Neutral; U = Underperform. Source: Credit Suisse estimates China-HK Chronicles 16

17 7 August 214 Recent market developments Market performance in July 214 Index and by MSCI sectors MSCI China and Hang Seng H share (HSCEI) were up by 7.% and 7.1%, respectively. The best performing MSCI sectors were real estate (+18.%), materials (+12.8%) and telecoms (+12.1%). On the other hand, utilities (+1.%) and consumer staples (+1.1%) were the worst performers. MSCI Hong Kong and Hang Seng Index (HSI) were up 3.8% and.3%, respectively. The best performing MSCI sectors were diversified financials (+1.6%) and insurance (+6.7%). Information technology (-2.7%) and capital goods (-.%) were the worst performers. Real estate, materials and telecoms were the bestperforming MSCI China sectors Diversified financials and insurance fared the best in Hong Kong Figure 29: Monthly performance of MSCI China by sector Figure 3: Monthly performance of MSCI HK by sector Source: MSCI, Thomson Financial Datastream Figure 31: Top and bottom performers China HK26 Aluminium Corp. of China 'H' 3.2 HK991 Datang Intl.Pwr.Gnrtn. 'H' 28.4 HK966 China Taiping In.Hdg. 2.9 HK29 BBMG 'H' 23.8 HK27 Country Garden Holdings 23.4 HK1112 Biostime Intl.Holdings (18.4) HK267 Shanghai Pharms.Hldg. Co.'H' (7.4) HK2196 Shai.Fosun Pharm.(Group) 'H' (6.4) HK2313 Shenzhou Intl.Group.Hdg. (6.2) HK392 Beijing Enterprises Hdg. (6.1) Source: MSCI, Thomson Financial Datastream Hong Kong HK2 Wheelock and Co HK388 Hong Kong Exs.& Clear. 17. HK4 Wharf Holdings 9.2 HK1972 Swire Properties 9.1 HK2388 BOC Hong Kong (Hdg.) 8. HK6823 HKT Trust & HKT (2.8) HK669 Techtronic Inds. (2.8) HK1928 Sands China (2.7) HK22 ASM Pacific Tech. (2.7) HK11 Hang Lung Properties (2.1) Note: The numbers on the right-end column of each table indicate percentage change in price during July. Source: MSCI Earnings momentum 214E and 21E EPS for MSCI China were up.% and.%, respectively in the past one month. Sectors that saw the biggest EPS upward revision for 214 were healthcare (+1.3%) and utilities(+1.%). On the other hand, we saw the biggest EPS downward revisions for transportation (-2.8%) and consumer staples (-2.%). China: Upward revisions maximum in healthcare and utilities China-HK Chronicles 17

18 7 August 214 For MSCI Hong Kong, 214 and 21 EPS were down.2% and.%, respectively in the past one month. Sectors that saw the biggest EPS upward revision for 214 was telecoms (+2.9%). On the other hand, we saw the biggest EPS downward revisions for transportation (-2.9%) and consumer discretionary (-1.6%). Hong Kong: Upward revisions maximum in telecoms Hang Seng Index (HSI) and Hang Seng H share (HSCEI) 214 EPS were down.1% and up 2.2% (21 EPS: -.2% and +2.2%), respectively, in the past one month. Figure 32: EPS integers MSCI China Figure 33: EPS integers MSCI Hong Kong Figure 34: EPS integers one-month change China Figure 3: EPS integers one-month change Hong Kong Net upgrades (number of upgrades less downgrades as a percentage of total number of estimates) for MSCI China were -2.7% (137 upgrades and 213 downgrades among 2,787 number of estimates) in July versus -.3% in June. Net upgrades for MSCI Hong Kong were -6.% (3 upgrades and 76 downgrades among 63 number of estimates) in July, versus net upgrade of -1.6% in June. Negative upgrade for MSCI China and MSCI Hong Kong China-HK Chronicles 18

19 7 August 214 Figure 36: Net upgrades MSCI China Figure 37: Net upgrades MSCI Hong Kong Valuation table EPS growth (%) P/ E (x) Trailing 31-Jul P/ B (x) ROE (%) DY (%) MSCI China Consumer discretionary Autos Retailing Consumer staples Energy Financials Banks Insurance Real estate Healthcare Industrials Capital goods Transportation Information technology Materials Telecommunication services Utilities MSCI Hong Kong Consumer discretionary Financials Banks Div. financials Insurance Real estate Industrials Capital goods Transportation Telecommunication services Information technology Utilities Hang Seng Index H Share Index Source: MSCI, IBES Aggregates, HSI China-HK Chronicles 19

20 7 August 214 Figure 38: China select economic indicators National accounts, population and unemployment F 21F Real GDP growth (%) Growth in real private consumption (%) (1) Growth in real gross fixed capital formation (%) (2) Fixed investment (% of GDP) Nominal GDP (US$ bn) 3,49 4,14 4,994,969 7,29 8,26 9,247 1,49 11,17 Population (mn) 1,321 1,328 1,33 1,342 1,348 1,3 1,362 1,369 1,376 GDP per capita (US$) 2,64 3,399 3,742 4,449,41 6,9 6,788 7,339 8,17 Unemployment (% of urban labour force, average year) Prices, interest rates and exchange rates CPI inflation (%, December over December) CPI inflation (% change in average index for the year) Exchange rate (RMB per USD, end-year) Exchange rate (RMB per USD, average) REER (% year-on-year change December to December) (3) Nominal wage growth (% YoY change, average) One-year lending rate (%) Three-month interbank rate (%, end-year) Fiscal data General government fiscal balance (% of GDP) General government primary fiscal balance (% of GDP) General government expenditure (% of GDP) Gross general government debt (% of GDP, end-year) (4) Money supply and credit Broad money supply (M2, % of GDP) Broad money supply (M2, % year-on-year change) Domestic credit (% of GDP) Domestic credit (% year-on-year change) Domestic credit to the private sector (% of GDP) Domestic credit to the private sector (% year-on-year change) Balance of payments Exports (goods and non-factor services, % of GDP) Imports (goods and non-factor services, % of GDP) Exports (goods and non-factor services, % increase in US$ value)* Imports (goods and non-factor services, % increase in US$ value)* Current account balance (US$ bn) Current account (% of GDP) Net FDI (US$ bn) Scheduled external debt amortisation (US$ bn) () Foreign debt and reserves Foreign debt (US$ bn, end-year) Public (US$ bn) (6) Private (US$ bn) Foreign debt (% of GDP, end-year) Foreign debt (% of exports of goods and services) Central bank gross FX reserves (US$ bn) 1,28 1,946 2,399 2,847 3,181 3,278 3,79 3,932 4,24 Central bank gross non-gold FX reserves (US$ bn) 1,24 1,942 2,389 2,83 3,19 3,21 3,68 3,91 4,221 (1) Calculated based on annual GDP data released by the NBS. (2) Calculated based on annual GDP data released by the NBS. (3) Real effective exchange rate: increase indicates appreciation. (4) Includes treasury bonds and foreign state debt owed by the State Council only. 21 level is estimated to be.3%, including local governments affiliated debt. () Scheduled and estimated amortisations for medium- and longterm public and private sector debt. (6) Public debt defined as direct loans by government, state banks and SOEs, excluding trade credit. * Exports and imports growth forecasts for 213 and 214 based on figures after the government s policy against carry trades. Source: National Bureau of Statistics, People s Bank of China, CEIC, Credit Suisse research China-HK Chronicles 2

21 7 August 214 Figure 39: Hong Kong select economic indicators F 21F National accounts, population and unemployment Real GDP growth (%) Growth in real private consumption (%) Growth in real fixed investment (%) Fixed investment (% of GDP) Nominal GDP (US$ bn) Population (mn) GDP per capita (US$) 29,828 31,28 3,277 32,281 3,1 36,716 38,11 4,32 41,88 Unemployment (% of labour force, end-year) Prices, interest rates and exchange rates CPI inflation (%, December over December) CPI inflation (% change in average index for the year) Exchange rate (HKD per USD, end-year) Exchange rate (HKD per USD, average) REER (% year-on-year change December to December) (1) Nominal wage growth (% YoY change, average) Three-month HIBOR (%, end-year) Fiscal data General government fiscal balance (% of GDP) General government primary fiscal balance (% of GDP) General government expenditure (% of GDP) Gross general government debt (% of GDP, end-year) (2) Money supply and credit Broad money supply (HKD M2, % of GDP) Broad money supply (HKD M2, % year-on-year change) Domestic credit (% of GDP) Domestic credit (% year-on-year change) Domestic credit to the private sector (% of GDP) Domestic credit to the private sector (% year-on-year change) Balance of payments Exports (goods and non-factor services, % of GDP) Imports (goods and non-factor services, % of GDP) Exports (goods and non-factor services, % increase in US$ value) Imports (goods and non-factor services, % increase in US$ value) Current account balance (US$ bn) Current account (% of GDP) Net FDI (US$ bn) Scheduled external debt amortisation (US$ bn) (3) Foreign debt and reserves Foreign debt (US$ bn, end-year) (4) Public (US$ bn) Private (US$ bn) Foreign debt (% of GDP, end-year) Foreign debt (% of exports of goods and services) Central bank gross FX reserves (US$ bn) Central bank gross non-gold FX reserves (US$ bn) (1) Real effective exchange rate, increase indicates appreciation. (2) Also includes debt issued under the Government Bond Programme. Excludes debt guaranteed by the government. (3) Scheduled and estimated amortisations for total medium- and long-term public and private sector debt. (4) Non-bank foreign debt to Hong Kong entities. Source: Census and Statistics Department, Hong Kong Monetary Authority, CEIC, Credit Suisse research China-HK Chronicles 21

22 7 August 214 Corporate access China Global Brands Consumer Tour September 17-19, 214, China The Credit Suisse Consumer team will be hosting a trip to China this fall. The focus of the trip is to explore both domestic consumption as well as the impact of China s influence on the consumer supply chain elsewhere in the world China Property Fact-Finding Tour September 19-23, 214, Macau, Zhuhai, Chongqing and Chengdu (a) Central government recently re-emphasized investment in West China (Chengdu & Chongqing) and Free Trade Zones (Hengqin); (b) CR Land's Chongqing MIXc shopping mall will open in September - also check on Wharf's IFS in Chengdu; (c) September is a crucial month for housing sentiments and should set the trend for the rest of the year; (d) Talk to local agents, private property investors, and local government officials Explore domestic consumption and the impact of China s influence on the consumer supply chain elsewhere Find China property fact. China-HK Chronicles 22