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1 STRATEGY A-SHARE MARKET OUTLOOK 2016 Our A-share strategy team held the investor conference for 2016 market outlook last week and we summarized some key points about macro and strategy below: MACRO OUTLOOK: PAY ATTENTION TO LIQUIDITY RISK 2016 GDP growth to be 6.5%-7%. The year-on-year (YoY) growth of most major economic indicators (e.g. industrial production, power generation, railway transportation, etc.) continues to slow down without a clear sign of rebound. PMI data also remains lacklustre. Therefore the trend of slower GDP growth is unlikely to be altered and our A-share team expects the economic growth next year will be about 6.5%-7%. Economic transformation continues. Although the overall picture is not very encouraging, we see some progress in economic transformation process. Consumption s contribution to GDP growth increased from 48.2% in 2013 to 58.4% in Q3 2015, higher than investment s contribution of 43.4%. Excluding the property sector, investment in tertiary sector still maintained >15% growth in 9M2015. Figure 1: Contribution share to China s GDP growth Figure 2: Diverging sector performance % % Q 4-09 Q 4-10 Q 4-11 Q 4-12 Q 4-13 Q 4-14 C ontribution S hare to G D P G row th: P relim inary: Final C onsum ption E xpenditure C ontribution S hare to G D P G row th: P relim inary: G ross C apital Form ation C ontribution S hare to G D P G row th: P relim inary: N et E xports of G oods and S ervices D ata S ource:w ind Info Source: WIND Info Divergent performance in various sectors. As a result of economic transformation, outlook of various sectors is diverging. For instance, climate indices for pharmaceuticals and food manufacturing remain resilient while the indices of investment driven sectors like coal and steel are weak. Revenue growth and profit growth of private enterprises outperformed state-owned enterprises (SOEs). Growth of industrial production in east and southwest China was much better than that in north China. Unemployment rate looks stable but distorted by two factors. Registered unemployment rate in cities and towns stayed at 4%- 4.1% but it was distorted by (i) rural labor who returned to their home provinces was not counted in registered unemployment rate in cities and towns and (ii) new labor addition declined due to lower birth rate. Key concerns in 2016: liquidity in China and overseas. Although there is ample room to cut required reserve ratio (RRR) further next year, there is not much room to cut interest rate as the US is likely to start raising interest rate gradually this month. Fund outflow caused by concerns about RMB depreciation is also an unfavourable factor to market liquidity. Based on international case studies (including Chile, Argentina, Philippines, Uruguay, Malaysia, Turkey and Taiwan), interest rate deregulation seldom went smoothly (except Malaysia), which may lead to unexpected volatility in interest rates. From an international perspective, M2 of the US no longer grows rapidly and further room for quantitative easing (QE) in Europe and Japan may be smaller than market expectation due to rising public debt/gdp ratio. 1

2 Figure 3: Contribution share to China s GDP growth Figure 4: Industrial production growth by region (%) Figure 5: US M2 no longer grows rapidly Figure 6: Rising government debt in Euro zone No financial crisis in China but may be affected by other emerging markets. With a huge monthly trade surplus as a buffer, our A -share team does not expect to see a financial crisis in China. However, in case rising external debt of some emerging markets, such as Brazil and India, trigger a financial crisis, China will be affected indirectly. Overall, our A-share macro team does not expect to see a clear secular trend in 2016 for A-share market. Therefore market timing and sector picking will be key factors to outperform. 2

3 Figure 7: Rising external debt of Brazil Figure 8: Increasing external debt of India STRATEGY: FOCUS ON TRANSFORMATION AND GROWTH Unexciting earnings outlook for the overall A-share market. Revenue growth continued to decelerate due to falling commodity prices. Earnings growth may pick up mildly as some sectors will benefit from rate cut and lower production cost as a result of low commodity prices. However, overall profit growth remains lacklustre and A-share market valuation is still high from a profit growth perspective. Focus on supply side reform. Real estate and property sectors can no longer be the key growth drivers of the economy. Innovation will be the key driver to support economic growth. To improve the quality and efficiency of supply, supply side reform will play a very important role during the 13th Five-year Plan (FYP). Three key themes are: (i) lifestyle - brand and life style in cities; (ii) industry - Made in China 2025 and smart devices; (iii) technology - innovation and new technology. Upgrade and growth of local brands. High-end consumer goods and many mass market consumer goods are still dominated by foreign brands. It is important for domestic brands to enhance their brand premium to raise profitability. In highly competitive subsegments, investors should focus on domestic companies with increasing brand recognition, a key driver for share price. In subsegments with an oligopoly structure, investors should focus on leading players for stable return. The theme of Big Health. Aging population is an inevitable trend in China while the country s medical expenses per capita on PPP basis was merely US$233, far below major western countries of >US$3,000. In future, China pharmaceutical companies with strength in R&D and innovation will be winners. Based on the trend of disease in China, our A-share team believes investors should focus on companies with strength in following areas: (i) cardiovascular and cerebrovascular disease; (ii) cancer; (iii) diabetes; and (iv) AIDS. Ex-IOE. Increasing penetration rate of domestic technology and equipment companies will be a key to achieve the goal of Made in China It is also important to enhance national security. The trend of ex-ioe (gradually reduce the use of IBM servers, Oracle database and EMC storage systems and use more open source system developed domestically) will help Chinese players move higher in the international value chain. No major secular trend in 2016; focus on themes and selective sectors. As it will be unlikely to see a clear secular trend for traditional sectors, our A-share strategy team recommends investors to focus on the following five areas: (i) Big Health - companies with stronger innovative capability; (ii) smart devices which will benefit from Made in China 2025 ; (iii) leaders in mobile internet; (iv) companies related to information security; (v) domestic consumer brands and domestic entertainment brands. 3

4 For reference: December A-share portfolio recommended by our A-share team - The portfolio for December includes one each in petroleum and petrochemical, machinery, military industry, new materials, real estate, electronics, communication, medical, textile and apparel, and food and beverage. The ten stocks include HBP (002554), SJEC (601313), Aerospace Times Electronics (600879), Nbtm New Material (600114), Langold Real Estate (002305), Sunway Communication (300136), Fiberhome Telecommunication (600498), Tofflon Science and Technology (300171), Lianfa Textile (002394), Terun (600419). Selected stock ideas for Hong Kong listed companies based on the call of our A-share team: Big Health: - CSPC Pharmaceutical [1093.HK; BUY]: The company focused on innovative drugs, branded generics and bulk medicine, which respectively accounted for 30.9%, 35.5% and 33.7% of revenue in 1H15. While innovative drugs only accounted for 30.9% of revenue in 1H15, they accounted for over 50% of gross profit due to their high margin. Moreover, we expect innovative drugs revenue to grow at ~30% in the next few years. The company has in total 170 drugs under development, of which 14 are class 1 new drugs, 46 are class 3 new drugs and 17 US ANDA drugs. These large pipeline ensure continuous launch of new products to support growth. We expect E EPS CAGR of 31.7%. The company currently trading at 2015E/16E PER of 26.7x/20.5x. Our TP of HK$8.82 implies 15E/16E PER of 30.8X/23.9x. Made in China 2025: - Wasion Group [3393.HK; BUY]: Internet of Energy and power reform are two key development areas of both State Grid Corporation (SGC) and China Southern Grid (CSG) starting from 2016, which will result in demand for high-end power transmission and distribution equipment. Wasion Group s (Wasion) management highlights that installation of charging infrastructure and solving grid connection issue of the renewable energy sources by SGC will create growth potential to Wasion. Management reiterates that exports sales growth and other metering products are also contributing to top line growth in future. Concerns on growth outlook for Wasion is expected to fade out. Wasion will report steady growth going forward. We maintain the view that share price consolidation after its share placement in early May 2015 provides good re-visit opportunity. Maintain BUY with a target price of HK$11.87 (17x 2015E PER). Release of investment plan for by power grids and details of power reform are share price catalysts. Information security: - Kingdee [0268.HK]: We maintain the view that Kingdee s top-line growth will accelerate in 2H 2015 as the impact of sales channel restructuring is near the end. The group will control SG&A expenses, while finance costs should peak out. Kingdee is one of the first movers in cloud based IT services, which is expected to benefit from government policy of promoting cloud computing. Cooperation with other industry players including JD.com, Amazon and Kingsoft for promoting cloud based products will create growth opportunity to Kingdee. 4

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Explanation on Equity Ratings BUY SELL HOLD : : share price will increase by >20% within 12 months in absolute terms share price will decrease by >20% within 12 months in absolute terms : no clear catalyst, and downgraded from BUY pending clearer signal to reinstate BUY or further downgrade to outright SELL Copyright Reserved No part of this material may be reproduced or redistributed without the prior written consent of China Galaxy International Securities (Hong Kong) Co., Limited. China Galaxy International Securities (Hong Kong) Co. Limited, CE No.AXM459 Room , 35/F, Cosco Tower, Grand Millennium Plaza, 183 Queen s Road Central, Sheung Wan, Hong Kong. General line: