a closer look at the 2013 investment view on china

Invast Insights

Week Commencing September 16, 2013

www.invast.com.au | 1800 468 278

Quote of the week

The miracle is not to fly in the air, or to walk on the water; but to walk on the

earth. - Ancient Chinese Proverb

1.0 What is happening in China?

Chinese data continues to surprise in recent weeks. One of the things we find

most humorous about the market is phrases like the "Chinese recovery" and

others which suggest that China is emerging from a problem. To put things

into context, China as the world's second largest economy has still managed

to grow at a pace greater than twice the average of most developed

economies, including Australia. Sure the pace of Chinese growth has slowed

over the past eighteen months but the economy is by no means coming out

of a deep slumber like the rest of the developed world.


This week's Chinese data highlights the strength of its economy and has sent

bears hiding back in their caves. Industrial production in China grew by 9.5%

last month and 9.4% in July. Let's keep that into perspective. Retail sales

added a whopping 12.8% which was in line with the rate of growth reported

in July. The big question among markets now is, whether consensus of GDP

growth in the order of 7.5% is too low? Many investment banks have already

started to increase their numbers just below 8%.

The market is finally realising that China is not about to implode anytime

soon and the slowdown in growth over the past two years has been an

engineered, policy drive event aiming to achieve two things:

1. A moderation in the rate of inflation, which causes social instability; and

2. A realisation that growth must be sustainable, with nationwide

inefficiencies targeted


1.1 How we think of China

An investment view on China needs to consider one of the most important

underlying elements - the ability of the central government to navigate its

way through challenges. The Communist Party needs the economy and

associated flows of capital in order to sustain its existence. For many Chinese,

this is the only system of government they have known. The US and European

economies can withstand a severe financial shock without a shock to the

underlying system of government, but in China the same does not hold.

The Communist Party will do all it can in order to sustain social and political

order and the economy is to a large extent the most important part. A

collapse in China's economy could see a collapse in the system of

government, something the ruling party cannot tolerate. So, the allocation of

resources and fiscal approach is not purely driven by short-term economics.


Therefore we think inflation in China is the greatest risk to the social and

economic balance which has seen standards of living lift so dramatically over

the past two decades. China's rate of growth will be a function of its inflation

tolerance. The chart below shows why the Chinese authorities needed to put

a lid on the rate of growth over the past two years.


The extreme points in the chart coincide with drastic policy action. In 2009,

the Chinese government embarked on one of the most aggressive fiscal

stimulus measures in its history in fear that deflation would stall the

economic growth trajectory and in early 2013, with inflation at a dangerous

6% plus level, things were pared back. For us, this is the most important piece

of information in deciding where China goes in terms of growth.

When inflation ramps up and flows through to higher food prices (like pork

for example in 2012), the government will become very sensitive to social

concerns and seek to even out the cycle. Food accounts for around 32% of the

Chinese inflation measurement, followed by residence costs at 17% and

transportation at 10%. These three basic elements, which resonate so

profoundly with the emerging lower and middle class, combined reflect

almost 50% of the inflation basket. When inflation goes up in China, the vast

majority of the population feels the heat.


1.2 Why steel production matters

So with inflation firmly in our mind, the other important data set we watch for

is steel production numbers out of China. Put frankly, China is the largest steel

factory in the world by a massive factor. The chart below shows just how

much steel China produces relative to the rest of the world. Since we cannot

comprehend the size and scale of China's economy, trends in the pace of steel

manufacturing do sometimes correlate very well with other industrial trends

in the country.


Source: World Steel Association via wikipedia.org


As displayed above, China currently produces more than four times the total

amount of steel produced in the entire European Union and more than six

times the amount produced in Japan. Five years ago the ratio of difference

was much smaller. Some estimates put the number of Chinese steel mills

anywhere between 2600-2800. China has a labour force of around 935 million

people of which in 2012 around 770 million were employed according to

statistics released by the Ministry of Health and Human Resources. Of this,

around 30% work in secondary industries like manufacturing compared to

21% back in 1990.

The steel manufacturing industry is crucial to Chinese employment and all

other related industries. What happens in Chinese steel production will have a

huge impact on where the Chinese economy goes and so forms a crucial part

of the puzzle which we monitor. We don't foresee the doomsday scenarios of

China slashing its steel manufacturing industry and shedding millions of jobs

because to be frank, this will cause a huge amount of social disorder which

will flow through to the rest of the economy.


1.3 Fortescue Metals expresses its views

The slides below are from Fortescue Metals' recent release to the stock market

and paints some very interesting perspectives on what we have written

above. Sure Fortescue has a vested interest in the health of China - iron ore is

the key commodity for manufacturing steel - but the presentation slides also

balance out the argument against doomsday merchants.


1.4 China in a medium term timeframe

As you can tell, we are bullish on China. Basically as a quick reference guide

inflation and steel production are the numbers we watch. Our bullish view will

not be shaken by short term movements or news flow, but by what the

Chinese central government is doing in terms of policy.

Beijing recently finalised plans for a Central Plains Economic Zone - a region

that has traditionally served Northern China's agricultural belt and been an

important corridor for the transport of goods between rural and coastal

economic centres. The new zone will cover almost 300 thousand square

kilometers and encroach into Henan and neighbouring provinces. The aim is

to create a buffer to any social fallout in the moderating economic activity in

the coastal hubs. As workers migrate back inland, the aim is to have the

Central Plains regions be self-sufficient so workers can bring back their capital

and skills with job prospects.


The Central Plains Economic Zone is expected to commence in 2015 and will

by then be the largest single zone in terms of land mass and population.

Perhaps the recent rally in iron ore prices and steel manufacturing rates

reflect the anticipation of these expansion measures. The region also houses

an enormous and relatively young population, which means it has a large

potential labour force and decent consumer base.

We note this not because the Central Plains Economic Zone is likely to solve

all of China's economic issues, but because it is an example of a new strategy

to shift growth policies inwards. The pipeline for future development

opportunities like this is huge and will underpin a very long investment

process in China, which in turn will require global commodities like iron ore.

There will be a timing gap between new projects like the Central Plains

Economic Zone coming online and the 2009-led intensive construction boom

phasing out. But the market is finally starting to understand that China is not

a one-trick pony and any investment view must have a medium-term horizon

with a close eye on inflation and steel production levels.


2.0 We all need a little Vision

We touched on the mobile telecommunication space in Invast Insights for the

week commencing September 9, 2013.

One of the companies that we think also deserves a mention is little known

Vision Eye Institute (VEI). It was actually one of our hidden gems which were

outlined in our first publication last month. Vision is basically the largest

provider of ophthalmic care in Australia, diagnosing and treating people with

eye disorders and diseases. As more people use mobile devices, we can't help

but think of the health consequences in ten or twenty years time. Vision is

perhaps the best placed Australian stock market exposure if you think the

demand for eye treatment and surgeries is set to explode.

Vision has 34 doctor partners, 19 associates and 15 visiting surgeons all

working under its banner. They specialise in areas of cataract surgery,


vitreo-retinal surgery and treatment for macular degeneration, refractive

surgery, glaucoma treatments, corneal surgery, and ocular plastics treatment

and surgery. Both authors of this report currently wear reading glasses and

we both have two children each that are glued to their mobile devices. We

cannot envisage that their generation will have to pay the consequences of

being glued to a screen for more than half the day without damage to their

eyes. Vision is a great way to play that investment theme if you agree but you

need to have a little patience and vision, excuse the pun.

2.1 What do the numbers look like?

Vision generated around $25.3m in operating pre-tax earnings for the

financial year that just passed which was in line with guidance of $25-26m.

Being a medical business, some of the rates it charges for procedures is

subject to government regulation and healthcare insurance funds payment

schedules, so the market will become fragile in the short-termon any

suggestion of pricing movements.


The group had previously held a bit of a debt issue but debt was reduced

throughout the year from $85m to a more comfortable and appropriate

$47.5m via a capital raising. Net debt at the end of July was at $37m.

At around $0.70 the current market capitalisation sits at around $112m.

Adding back the debt the total firm value is just shy of $150m which means

the group is trading on an underlying earnings multiple of around 5.9x. This

doesn't seem like a screaming buy on face value but many larger healthcare

stocks traded at much higher levels and Vision should really be compared to

those peers as opposed to the rest of the market. The problem we find with

investing in the healthcare space is that you either pay a huge multiple for

the larger names like Ramsay Healthcare or Sonic Healthcare or you are

forced to take a punt on a biotech which promises to change the world but

very rarely rewards shareholders who bare a huge amount of risk.


We like Vision because it sits somewhere in the middle - a proven and

profitable business without the hefty price tag which larger peers command.

Plus we like the fact that as mobile devices grow in popularity and the

population continues to age, the demand for eye-care and ophthalmic

treatment is only set to explode.


Source: 2013 result presentation released to the stock exchange 27 August 2013

2.2 Key priorities going into 2014


2.3 Outlook and guidance

It has been a bit of a rocky ride over the past few years for the company. Total shareholder returns have averaged 89.9%, 49% and negative 3% on an annual basis over the past one, three and five years respectively. Management is now trying to keep things under control, debt is no longer a major issue and the market wants to start seeing some earnings growth consistency before it starts expanding the multiple it pays. What's most interesting for us is the fact that Primary Healthcare did own 19.8% of the stock but some dilution post capital raising has seen this fall to 15.6%. This is still a large investment, which means it has its eye on the major prize (excuse the pun again, we just couldn't help ourselves).

Key initiatives now include greater utilisation of the group's day surgeries and sniffing out expansion opportunities via acquisitions or adding to the network of doctors and associates. There will be a trading update to the market in late October at the company's AGM so the stock will be traded going into this event.


3.0 Forex pairs outlook for targets

The following technical outlook employs Ichimoku Kinko Hyo, fibonacci

retracement levels and basic understanding of chart patterns. Throughout the

month of September, Vito Henjoto our Senior Technical Strategist runs an

online workshop that covers these methodologies in detail.

To register please head to www.invast.com.au/webinars . This will be a client

only, one-off event. Once the training period is over an appendix outlining

basic information of the indicators and method used in the outlook will be

included.

All charts follow the below commentary separately at the end of this

discussion piece.

http://www.invast.com.au/webinars








3.1 GBPUSD discussion

As one of the stronger performing nations in the past few months, the pound sterling has gained significantly against the US dollar. Both the daily and weekly chart shows price trading above the Ichimoku cloud, a sign that a major turn in trends is happening. The first significant resistance at 1.6025 is inline with 78.6% fibonacci retracement level (weekly) followed by Decemeber 30th(2012) high at 1.6350. In our opinion a return to such levels is a possibility during the fourth quarter of the year but for this report we want to focus on the more immediate outlook for the pair.

A closer look on the daily timeframe reveals that the pair has been trading within an up-trend channel since July 2013. While we still have our eyes on 1.6000 and beyond, it is a much healthier option for the market to ease off the overbought condition from the recent rallies. There are 3 major and significant supports located at 1.5725, 1.5575 and 1.5425 that needs to be cleared out before the current trend is disrupted. Amongst the three 1.5725 is the ideal pullback level while 1.5575 would be the ultimate limit the pair can pullback whilst maintain a strong bullish momentum.


We expect buyers to come back into the market around 1.5725-1.5750

propping the market up and we call bullish on the GBP/USD in this fourth

quarter eyeing a potential return towards 1.6000 and 1.63000 by December

2013.

3.2 EURUSD discussion

Throughout the second and third quarter of this year the pair struggles to

recover from the fall in the first quarter of the year. This has resulted in the

pair creating wild swings giving the impression of a very volatile market both

for fundamental reasons with the debt crisis as well as technical perspective

of an indecisive market with very large market movement. In reality though

the pair is simply obeying key support and resistance level as can be seen

from the daily chart below.


There are four key levels we can refer to in the fourth quarter and those are

supports at 1.3100 and 1.2750, whilst resistances are located at 1.3425

followed by 1.3650. In the shorter time period we are likely to see the

EUR/USD progressing higher first on the back of the current bullish

momentum from the recent bounce off 1.3100 support just about a week ago.

The pair is also currently trading above the Ichimoku cloud on the daily time

frame, but once price reaches 1.3425 there might be a possibility for the pair

to be rejected maintain the current range between 1.2750 – 1.3425 the pair

has been traded in for the last two quarters. For now though we are bullish on

the EUR/USD until it reaches and test 1.3425 again.

3.3 USDJPY discussion

With the pair coming off the major symmetrical triangle we often discuss

during the live market analysis on Wednesdays and blog posts; the pair has

taken off in the past 2 weeks before coming up against resistance at 100.50


earlier this week. For now the pair is back traded above the Ichimoku cloud,

but slightly overbought and facing 100.50 resistance. There are two possible

scenarios here; a direct continuation up should the pair managed to

successfully break above 100.50 or a quick pullback to ease off the

overbought condition before pushing higher beyond 100.50.

We favor the later and expects price to pullback towards 97.50 – 97.75 support

area where the Ichimoku cloud support meets previous triangle support and

resistance trend lines we are estimating this to occur towards the end of next

week should the pair loses its footing at 99.00 psychological level. Throughout

the past 2 weeks I have strongly expressed my opinion on the sustainability

of the AUD/USD rally from the lows of 0.8890 and while the rally is impressive

my concern was on how the oscillators are not reflecting the current rally. To

make things worse the rally in AUD/USD continues without any major

retracement.


3.4 AUDUSD discussion

The Australian employment report seems to be the final nail that stopped the

rally on its track right around the key resistance level at 0.9300 – 0.9330

regions which also coincides with the resistance limit of the Ichimoku cloud.

Australia’s unemployment rate jumped up to 5.8% while employment change

sheds another 10,800 jobs; a far cry from the expected 10,200 gain for the

month of August. You can refer back to our initial post raising our concerns

via the Invast Blog section of the website.

Going forward we are likely to see further drops in the AUD/USD first towards

support at 0.9050 where price has previously found temporary support. This

level is also the support limit of the Ichimoku cloud, and should price trade

below this level it will trade outside of the cloud. When price trades within the

Ichimoku cloud it is often seen as indecision in the market, therefore if price

remains traded below 0.9050 downside momentum could pick up very

quickly.


Slow Stochastics is also showing signs of overbought and potential to cross

over and eases off the overbought condition. On the back of the rejection

from key resistance level at 0.9330 in combination with cloud resistance and

the overbought cond ition, we believe we will see further drop to the down

side initially towards 0.9050 and if the momentum is strong furth er towards

previous low at 0.8890.


Image: GBPUSD chart with discussion reference 3.1


Image: EURUSD chart with discussion reference 3.2


Image: USDJPY chart with discussi on reference 3.3


Image: AUDUSD chart with discussion reference 3.3


4.0 Client question and answer

Question: Dear Invast, I am mostly a currency/fx trader (about 20 yrs) and have

been reading the past few issues. Have been trading currency/fx because I don't

really understand stocks just want to know why I should bother looking at

stocks or corporate reports when they don't really apply to me. Are they

important/relevant for currency/fx traders like myself!?? -- John, Sydney

Answer: The basis for valuing any real asset always comes down to the

income that can be generated. For bonds, traders use the coupon payments

and discount them back to present value. Bonds then trade based on interest

rate expectations or expectations about the future return of the coupon vs.

alternatives source of income. For real estate, the savvy investors also look at

the rental income that the property can bring in before forming a basis on

valuation. Similarly with stocks, the company earnings are the underlying

factor for valuation and what occurs here plays an important part in each

company's share price.


When we use the word stock market, we are generally talking about a

collection of companies grouped together in an index. For example, the

ASX200 index is the most common measure of the Australian stock market. It

basically takes the top 200 listed companies and adjusts their share price

returns, weighted to the size of each company - or market capitalisation.

Individual share price movements therefore drive the stock market and

individual corporate earnings are the key swing factor in driving share prices.

To put this in a nutshell, if you want to know where stock prices are going

either on an individual or market basis, you really need to start looking at

corporate earnings first.

This is called the "bottom up" approach - looking through individual company

earnings to form a view on stock prices and stock markets overall. Some argue

that a "bottom down" approach is more appropriate - the underlying

fundamentals of the economy will drive what occurs to corporate earnings.


There is no right or wrong way to look at things - similar to a chicken or egg

coming first analogy. But at Invast we like to form bottom up views for a few

very simple reasons:

1. Listed companies are often large employers, their hiring intentions play an

important part in determining unemployment which in turn impacts

inflation and interest rate policy by central banks

2. Listed companies are also significant investors and buyers of goods and

services. Their earnings will often signal capital expenditure trends, which

in turn impacts inflation and interest rate policy by central banks.

3. Perhaps the most interesting one of all, listed companies are bound by

continuous disclosure obligations. They have to tell the stock market when

there are large changes in their earnings and so individual investors


have access to this transparent treasure trove of information to form their

views. It's very difficult to know what goes on within a central bank meeting

or fiscal policy setting, but corporate earnings are often very transparent.

Regardless of which markets you trade - Forex, commodities or equities - what

companies say usually impacts all three. Listed companies are a great source

of free information for those looking at forming a fundamental view on

markets and often dictate where fiscal and monetary policy goes. Hope that

helps John.


5.0 Disclaimer

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*Distributed with the permission of Invast.com.au

a closer look at the 2013 investment view on china

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