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2H16 Market Outlook

Jul 6, 2016 Equity Research | Investment Strategy

Three-pronged approach for 2H16: growth, defensive and policy plays

Alex Fan, CFA SFC CE No. ADJ672 [email protected] +852 3719 1047 GF Securities (Hong Kong) Brokerage Limited 29-30/F, Li Po Chun Chambers 189 Des Voeux Road Central Hong Kong

Market outlook Neutral

The Chinese economy is heading for “L-shaped” growth as the government addresses deep-rooted structural problems after enjoying an extended period of rapid growth over the past three decades. Although there are signs of a resumption of weak corporate earnings growth this year, there is a lack of bright spots in the short term overall.

There is limited room for a further drop in China’s risk-free rate, as the PBoC has relied increasingly on the use of non-traditional monetary policy measures such as reverse repos, targeted RRR cuts, pledged supplementary lending (PSL) and the medium-term loan facility (MLF), after six interest rate cuts since Nov 2014. The 10-year government bond yield has bottomed out in the wake of inflation expectations and the absence of aggressive easing policies.

Risk aversion continues to grow among investors given the uncertainty surrounding the struggle between SOE reform and economic growth, escalating credit default risk, and capital outflows.

Key themes over the next 3-6 months

Market visibility remains low There are many uncertainties affecting markets. These include:

continued deleveraging in both the corporate and finance arenas; progress in SOE reform and its implications for economic growth; the as-yet unknown official launch date for the Shenzhen-Hong Kong Stock Connect (expected before the year end); the still highly unpredictable US interest rate policy; the fact that the Brexit aftermath has just begun, and; the trend of Hong Kong-listed companies shifting to listing in the A-share market.

Valuation analysis

Limited scope for re-rating despite low valuation After stripping out de-rated Chinese

financials, the HSCEI ex-financials trades at about 10x P/E, which is still higher than the low of 6.1x seen in 2008 and hence not as attractive as the index appears (about 7x). However, the HSI recorded a maximum decline of 36% during the 10 months from Apr 2015 to Feb 2016, in line with the pattern during the market corrections seen in the last five crisis periods since 1994, indicating a strong likelihood that the Feb lows this year will provide strong market support.

Investment strategy

Cherry picking in a range-bound market We recommend leading quality stocks in high

growth sectors, defensive sectors and policy plays.

Top picks

Based on a combination of top-down and bottom-up approaches, we recommend a ten-stock watchlist as follows: Tongda (698 HK, Buy), Chinasoft (354 HK, Buy), IMAX China (1970 HK, Accumulate), Tencent (700 HK, NR), Geely Auto (175 HK, Accumulate), CSPC Pharm (1093 HK, Buy), Haitong International (665 HK, Accumulate), Huaneng Renewables (958 HK, NR), CT Environmental (1363 HK, NR), and Hengan (1044 HK, NR).

Risks

Upside risks: Better-than-expected results from SOE reform, the emergence of a turning point

in economic growth, and capital inflows. Downside risks: Earnings downgrades, rapid depreciation of the renminbi, sudden

appreciation of the US dollar, uncertainty surrounding the US presidential election, and Brexit contagion.

mailto:[email protected]

Jul 6, 2016

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2H16 Market Outlook

Performance review Crude oil was the best performer among major asset classes in 1H16, with

the price rebounding and stabilizing driven by expectations of a decline in output and a weakening US dollar after the panic selling seen throughout 2H15. The Japanese yen, gold and US$ bonds became safe havens as risk appetite among investors turned soar. The US market outperformed major global markets, while Hong Kong remained weak and was only able to catch up slightly in 2Q16. By sector, driven by the strong rebound in the crude oil price and expectations of a capacity shutdown under supply side reform, the oil and coal sectors outperformed the market significantly, while the tech sector recorded a positive return driven by stellar results. On the other hand, most macro-related sectors underperformed and recorded negative returns in 1H16.

Figure 1: 1H16 performance of major asset classes Figure 2: 2Q16 performance of major asset classes

Sources: Bloomberg, GF Securities (HK) Sources: Bloomberg, GF Securities (HK)

Figure 3: 1H16 sector share performance Figure 4: 2Q sector share performance


“L-shaped” economic growth with limited bright spots After decades of rapid economic growth,

China is facing a critical bottleneck in its economic development. The government has started to solve its structural problems and looks determined to prioritize structural adjustment over economic growth. In doing so, it is likely to tolerate “L-shaped” economic growth over the next few years, with relatively stable growth but at a slower pace than in previous years, meaning it is highly unlikely we will see substantial stimulus measures going forward. Hence, after the abnormally strong loan growth recorded in 1Q16, recent macro data has indicated a return to weak economic growth with little likelihood of a strong rebound in the near term.

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2H16 Market Outlook

Figure 5: Chinese GDP growth forecasts Figure 6: Slowdown in investment, consumption and industrial output

Sources: Wind, Bloomberg, IMF, World Bank, Xinhua News, GF Securities (HK)

Sources: Wind, GF Securities (HK)

The “three horses” of economic growth in China continue to lose steam. For instance, fixed asset investment (FAI) growth slowed further to 9.6% YoY in 5M16, the lowest level since 2000, of which private sector investment grew just 3.9% YoY, indicating a lack of investment motivation among private sector companies. In light of the likely peak in property sales in 2Q16, we expect FAI to come under further pressure in 3Q16. Retail sales grew just 10% in May, the same as last year’s record low. In fact, the slowdown in corporate earnings and weakness in global trade have started to have an effect on consumer spending, while a domestic supply mismatch has resulted in growing overseas spending and overseas shopping for the purpose of selling to others in China. Meanwhile, the global economic slowdown continues to be a drag on international trade and to dampen its contribution to GDP growth. 5M16 exports dropped 7.3% and imports fell 10.3% YoY.

Figure 7: Infrastructure the most resilient contributor to FAI Figure 8: Property and sports-related sales have seen strong growth

Sources: Wind, GF Securities (HK) Sources: Wind, GF Securities (HK)

Risk free rate has limited room to fall The PBoC has cut interest rates six times and lowered the

reserve requirement ratio (RRR) seven times since Nov 2014. The benchmark one-year lending rate now stands at 4.35% while the one-year deposit rate is 1.5%, lower than CPI in May (2.0%). Since last Nov, the PBoC has increasingly relied on non-traditional monetary policy measures such as reverse repos, targeted RRR cuts, pledged supplementary lending (PSL) and the medium term loan facility (MLF) in order to prevent additional depreciation pressure on the renminbi. Given the limited chance of large scale monetary easing, China’s 10-year bond yield seems to have already bottomed out, given inflation expectations and the absence of aggressive easing policies.

Source 2016E 2017E

IMF 6.5% 6.2%

World Bank 6.7% 6.5%

Bloomberg consensus 6.5% 6.25%

Government Work Reoprt 6.5-7% n.a. 0

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Total retail sales - monthly YoYJewelrySports and recreational goodsGarments and textilesCosmeticsFurnitureConstruction and decoration materials

Jul 6, 2016

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2H16 Market Outlook

Figure 9: Limited room to lower interest rates Figure 10: Risk free rate may have bottomed out


Risk appetite continues to deteriorate The market has high expectations for SOE reform and

supply side reform, which are meant to resolve China’s long-standing structural problems. However, the easy reform has already been completed and now the government is entering more difficult reform territory, with conflicting forces between reform and economic growth, while large-scale tax cuts could have a negative impact on the government’s debt level. Besides, credit default has spread quickly from private enterprises to SOEs and government-backed enterprises, leading to weak market sentiment in the debt market. Moreover, further appreciation of US dollar or an interest rate hike would undoubtedly lead to capital outflows and renminbi depreciation.

Figure 11: Supply side reform becoming more challenging Figure 12: Rising credit defaults

Sources: GF Securities (HK) Sources: Bloomberg, GF Securities (HK)

One bright spot: corporate earnings to see weak recovery After a 2015 filled with corporate

earnings declines, profits have begun to recover since 1Q16, supported by substantial liquidity and bank loans, especially during 1Q16. Earnings data released by the NBS indicated low-teen profit growth in the first five months of this year, following the negative growth during most of 2015, while earnings at A-share companies excluding financials also returned to positive growth in 1Q16. Given the low base last year, the market is now forecasting a weak single-digit earnings recovery for the next three quarters. H-share companies are also expected to resume earnings growth in 2017 after an earnings decline in 2016. However, the market may remain skeptical about future earnings growth given the weak macro environment.

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10-year Chinese government bond yield

Supply side Demand side

Tax reduction;Acceleration of fixed asset

depreciationIncreased fiscal expense

Monetary easing;Reduction of financing costs

Property demand stimulation

Overcapacity removal;SOE reform

“One Belt, One Road”

Simplification of government power;

Industrial restructuringConsumption upgrade

Issuer Related debtValue

(Rmb100m)

Shanshui Cement 13 Shanshui MTN1 18

15 Shanshui SCP002 8

Yabang Investment 15 Yabang CP001 2

Baoding Tianwei 11 Tianwei MTN1 10

11 Tianwei MTN2 15

Zibo Hongda Mining Industry 15 Hongda CP001 4

Nanjing Yurun Food 15 Yurun CP001 5

Dongbei Specia l Steel 15 Dong Tegang CP001 8

13 Dong Tegang MTN2 8

15 Dong Tegang CP002 7

Shanxi Huayu Energy 15 Huayu CP001 6

Inner Mongol ia Nai lun Group 11 Meng Nai lun Debt 8

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2H16 Market Outlook

Figure 13: Corporate earnings resuming slow growth Figure 14: A-share earnings recovering


De-leveraging ongoing in corporate and financial markets The comments from a high profile

“authoritative person” in the People’s Daily earlier this year highlighted the risk of leveraging in China. Over the past few months, we have seen increasing measures in the supervision of business risk in the financial markets from the PBoC, CBRC, CSRC and CIRC, indicating that the government prioritises controlling risk and lowering leverage in the market. On the corporate front, one of the key objectives of supply side reform is to cut capacity and lower inventory, helping to lower their leverage which has already reached significant levels. We expect de-leveraging to continue for a considerable period until leverage for both companies and financial markets has come down to a more reasonable level. During this period, the market is likely to remain in wait-and-see mode.

Figure 15: High corporate leverage Figure 16: Frequent policy announcements

Sources: Wind, GF Securities (HK) Sources: PBoC, CBRC, CSRC, CIRC, GF Securities (HK)

Cautious on Shenzhen-Hong Kong Stock Connect-related stocks, but brokers and TMT stocks likely to be winners We expect Hong Kong-listed brokerages with meaningful Hong Kong

business to be the main beneficiaries. The Shanghai-Hong Kong Stock Connect already accounts for about 10% of brokerage income for some leading brokers in Hong Kong, and we believe the implementation of the Shenzhen-Hong Kong Stock Connect will further strengthen their business, raising brokers’ earnings by 3-5%. In addition, we believe TMT stocks in Hong Kong remain attractive compared with their Shenzhen peers in terms of valuation, and hence should see their shares react positively. However, according to our analysis, most dual-listed A-H shares underperformed the market after the announcement of the Shanghai-Hong Kong Stock Connect, so we see a similar risk for investors chasing dual-listed names based purely on Stock Connect expectations.

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Regulatory authorities Policies

PBOC, CBRCNotice on the Strengthening of Bill Business Regulation and the

Promotion of Healthy Bill Market Development (Doc No.126)

CBRCNotice on the Regulaiton of Commercial Banks' Agency Sales

Business (Doc No.24)

Notice on the Regulation of Transfers of Banking Finanical

Institutions' Credit Assets Income Rights (Doc No.82)

CSRC

Administrative Rules for the Subsidiaries of Securities

Investment Fund Management Companies; Risk-Control Guidelines

for Fund Management Companies' Customer Asset Management

Subsidiaties

CIRC

Notice on the Strengthening of Compliance Management for

Insurance Companies (Doc No.38); Notice on the Regulation of

Insurance Asset Management Companies' Channel Business

Jul 6, 2016

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2H16 Market Outlook

Figure 17: Share price performance for selected names before/after SH-HK Stock Connect announcement

Sources: Bloomberg, GF Securities (HK)

Is “returning to the A-share market” a fad or a trend? Over the past few months, there has been

increasing interest from companies seeking an A-share listing by delisting in Hong Kong or spinning off part of their business in order to establish an A-share financing platform. Dalian Wanda Commercial Properties (3699 HK, NR), Peak Sports (1968 HK, Buy) and TCL Communication (2618 HK, Hold) have announced that they are planning to privatize their Hong Kong-listed companies and subsequently list in the A-share market, while China Harmony New Energy Auto (3836 HK, NR) plans to spin off its new energy business to the A-share market, Truly International (732 HK, Accumulate) is queuing for an A-share IPO for its lens business, and China Yongda Automobiles Services (3669 HK, NR) has successfully bought an A-share company and plans to inject its core business. While methods and approaches vary, the underlying reason is the low valuations these companies are seeing in the Hong Kong market, which have jeopardized their equity financing abilities. The A-share market commands much higher valuations, but a simple A-H dual listing will inevitably limit their A-share valuations. Returning to the A-share market is not new. There are more than 40 US-listed companies planning a return, but there have been limited successful cases so far. In light of concerns about capital outflows due to the funds required to de-list, and the potential impact of a supply increase to the already fragile A-share market, it has been reported that the CSRC is now reviewing its policy on overseas de-listed A-share listing cases and backdoor listings through shell companies with the possibility of tightening regulation. Indeed, the red chip nature and foreign shareholdings of these A-share listing candidates needs to be addressed, which may take months or even a year. Moreover, if these companies opt for complete privatization they will lose their overseas debt financing platforms. Hence, until we see more successful cases, we believe it is too early to tell whether returning to A-share market will become a trend. Valuations at the low-end but lacking re-rating catalysts The Hong Kong market has dropped

almost 30% from last year’s peak, and its valuation is approaching the trough seen during the global financial crisis in 2008 and the euro debt crisis in 2011. However, stripping out the distortion due to the large weighting of financials in the Hang Seng indices, the P/E of the HSI ex-financials is about 13x and the P/E of the HSCEI ex-financials is about 10x, about 1 standard deviation below their

Company Ticker -1M +1M Company Ticker -1M +1M

ICBC-H 1398 HK Equity 7.6 (5.3) SHANGHAI PHARM-H 2607 HK Equity (15.5) (19.0)

PETROCHINA-H 857 HK Equity 7.7 2.5 CHINA COSCO HO-H 1919 HK Equity (4.0) (9.9)

CCB-H 939 HK Equity 7.1 (5.5) DATANG INTL PO-H 991 HK Equity (1.0) (2.4)

ABC-H 1288 HK Equity 9.4 (7.1) JIANGSU EXPRES-H 177 HK Equity (6.5) (2.5)

BANK OF CHINA-H 3988 HK Equity 9.7 (3.7) FOSUN PHARMA-H 2196 HK Equity (11.4) (0.4)

SINOPEC CORP-H 386 HK Equity 3.5 (7.0) CHINA SHIPPING-H 2866 HK Equity (1.1) (2.7)

PING AN-H 2318 HK Equity 6.6 (15.5) XINJIANG GOLD-H 2208 HK Equity (19.2) (1.6)

CHINA LIFE-H 2628 HK Equity 2.7 (11.3) BBMG CORP-H 2009 HK Equity 15.3 (17.7)

CM BANK-H 3968 HK Equity 12.9 (9.2) JIANGXI COPPER-H 358 HK Equity 3.7 (8.4)

BANKCOMM-H 3328 HK Equity 7.4 (7.5) TSINGTAO BREW-H 168 HK Equity 0.1 (1.1)

CITIC BANK-H 998 HK Equity 13.1 (3.2) WEICHAI POWER-H 2338 HK Equity 4.6 (10.9)

CRRC CORP LTD -H 1766 HK Equity 17.9 (10.2) ZOOMLION HEAVY-H 1157 HK Equity 8.6 (14.8)

CHINA PACIFIC-H 2601 HK Equity 2.9 (11.3) BAIYUNSHAN PH-H 874 HK Equity (8.1) (10.9)

CITIC SEC-H 6030 HK Equity 8.8 (11.7) GUANGSHEN RAIL-H 525 HK Equity (3.1) (15.6)

CEB BANK-H 6818 HK Equity 4.5 4.9 CSSC OFFSHORE -H 317 HK Equity (15.0) 0.0

CHINA COM CONS-H 1800 HK Equity 3.3 (6.8) DONGFANG ELECT-H 1072 HK Equity (3.6) (7.9)

HAITONG SECURI-H 6837 HK Equity 8.5 (4.1) ANHUI EXPRESS-H 995 HK Equity 6.5 3.3

CHINA RAIL GR-H 390 HK Equity 18.2 (2.3) MAANSHAN IRON-H 323 HK Equity 5.6 (16.0)

CHINA RAIL CN-H 1186 HK Equity 22.6 (7.9) SHENZHEN EXPRE-H 548 HK Equity (2.0) 8.9

BYD CO LTD-H 1211 HK Equity (10.6) (24.2) LIVZON PHARM-H 1513 HK Equity (12.2) (7.7)

GUANGZHOU AUTO-H 2238 HK Equity 21.3 (10.8) DONGJIANG ENV-H 895 HK Equity (14.5) 4.1

NEW CHINA LIFE-H 1336 HK Equity 3.3 (4.8) SHANDONG CHEN-B 200488 CH Equity 5.7 (2.8)

HUANENG POWER-H 902 HK Equity 18.0 (2.3) BEIJING NORTH-H 588 HK Equity (1.6) (1.1)

SHANGHAI ELECT-H 2727 HK Equity (3.5) 8.3 SICHUAN EXP-H 107 HK Equity 8.6 2.6

ANHUI CONCH-H 914 HK Equity 15.4 (17.4) CHONGQING IRON-H 1053 HK Equity (4.6) 1.9

AIR CHINA LTD-H 753 HK Equity (5.0) (5.5) NANJING PANDA-H 553 HK Equity 4.6 18.9

CHINA EAST AIR-H 670 HK Equity (2.2) (12.9) TIANJIN CAP-H 1065 HK Equity (12.1) 6.6

GREAT WALL MOT-H 2333 HK Equity 25.6 (33.8) ZHENGZHOU COAL-H 564 HK Equity (2.0) (6.5)

METALLURGICAL-H 1618 HK Equity 13.2 1.4 HISENSE KELON -H 921 HK Equity (14.9) (20.2)

ZIJIN MINING-H 2899 HK Equity (0.6) 7.0 LUOYANG GLASS-H 1108 HK Equity 1.5 75.6

CHINA SOUTHERN-H 1055 HK Equity (4.6) (8.1) FIRST TRACTOR-H 38 HK Equity (14.1) 1.8

CMOC-H 3993 HK Equity 1.6 13.2 ZHEJIANG SHIBA-H 1057 HK Equity (6.0) 25.4

SINOPEC SHANG-H 338 HK Equity (18.8) (8.7) SHANDONG MOLON-H 568 HK Equity (6.5) 6.4

CHINA COAL ENE-H 1898 HK Equity 16.5 (4.0) NORTHEAST ELEC-H 42 HK Equity (3.5) 7.3

ZTE-H 763 HK Equity (1.6) (10.4) SHANDONG XINHU-H 719 HK Equity (16.5) (6.7)

SINOPEC OILFIE-H 1033 HK Equity (3.0) 1.2 SHENJI GROUP-H 300 HK Equity (6.6) 7.1

HUADIAN POWER-H 1071 HK Equity 28.5 4.2 INNER MONGOLIA-B 900948 CH Equity (6.0) 3.4

CHINA OILFIELD-H 2883 HK Equity 2.0 (7.6)

Share price (%) Share price (%)

Jul 6, 2016

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2H16 Market Outlook

historical means, but still higher than the 6.8x and 6.1x seen in the 2008 valuation trough, respectively. With this in mind, the current valuation is not particularly cheap.

Figure 18: HSI, P/E, ex-financials P/E Figure 19: HSCEI, P/E, ex-financials P/E


However, measuring from the peak in Apr 2015 to latest trough in Feb 2016, this period of decline for the HSI has lasted for ten months with a maximum decline of 36%, in line with the trend seen in the past five crisis periods since 1994, which have seen maximum declines of 35-67% over a period of 11-18 months. Given that the current financial crisis is not as serious as the one in 2008 or in 2011, we believe the Feb trough may have been the worst level and hence should provide a strong support level if the market continues to be weak. In fact, judging from the latest Hong Kong market decline triggered by the Brexit vote, we believe it is fair to say that downside is limited. That said, we do not see too much upside either, given the reasons mentioned above.

Figure 20: HSI (during the crises of 1994, 1998, 2001) Figure 21: HSI (during the crises of 2008, 2011 and now)


By sector, the valuations of banks, insurance, retailers, telecoms and public utilities are close to, or at, five-year lows. Autos, consumer staples, apparel, home appliances, and healthcare are attractively valued, while energy (oil), raw materials, internet and software, and tech hardware command high valuations.

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PE: 6.9 PE: 7.6Ex Fin PE: 8.2

PE: 9.0Ex Fin PE: 11.7

PE: 10.3Ex Fin PE: 13.4

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PE: 7.1Ex Fin PE: 10.4 PE: 6.0

Ex Fin PE: 8.2



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2H16 Market Outlook

Figure 22: Sector valuations (2011-2015 and current)


While overall corporate earnings are expected to resume a weak recovery, the tech hardware, software, internet gaming, environmental protection and auto sectors are expected to grow much faster, while oil, coal, insurance, securities and power equipment are expected to record a turnaround in earnings in 2017.

Figure 23: 2016 sector consensus earnings growth forecasts Figure 24: 2017 sector consensus earnings growth forecasts


Investment strategy We believe investors are waiting for signs of an earnings and/or economic

turnaround, and the chance of an improvement in risk appetite. During this period, the market is unlikely to see any one-sided trend. For 2H16, our portfolio strategy focuses on stock picking on three themes: 1) high quality leading stocks in high growth sectors such as tech hardware, software, internet and media; 2) defensive sectors such as consumer staples and healthcare (stable growth) or utilities and REITs (high yield), and; 3) policy driven sectors such as environmental protection, new energy and transport infrastructure. High quality leading stocks in high growth sectors

Tech hardware Although there is increasing competition in the smartphone and PC markets, as

market growth slows, we see opportunities in the upstream value chain. In particular, we believe dual cameras will become a standard feature for mid/high-end smartphones, fingerprint recognition penetration will jump rapidly, and metal casing usage will continue to grow, replacing plastic casings in the coming years. We believe companies with the ability to deliver these products will excel in the multi-year product cycle. Internet The internet sector is expected to continue to see high levels of growth, given the high

priority given to it in the government’s industry policy and the rapid innovation in internet applications,

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s

Tech

Har

d &

Eq

pt

Tele

com

Tran

spo

rtat

ion

Uti

litie

s

2011-2015 P/E Range Current P/E

-100

-50

0

50

100

150

200

250

Oil

Po

wer

Secu

riti

es

Insu

ran

ce

Co

nsu

mer

dis

c

Co

al

HSI

HSC

EI

Po

wer

eq

uip

men

t

Tele

com

Air

lines

Ban

ks

Po

rts

Mat

eria

ls

Co

nsu

mer

sta

ple

s

Sola

r

Pro

per

ty

Rai

lway

eq

uip

men

t

Win

d p

ow

er

Hea

lth

care

Envi

ron

men

tal

Tech

Soft

war

e

Au

to

Gam

ing

-50

0

50

100

150

200

250

300

Po

wer

Air

lines

Po

rts

Ban

ks

HSC

EI

Win

d

Rai

lway

eq

uip

men

t

Co

nsu

mer

sta

ple

s

HSI

Co

nsu

mer

dis

c

Co

al

Tele

com

s

Sola

r

Insu

ran

ce

Au

to

Hea

lth

care

Pro

per

ty

Po

wer

eq

uip

men

t

Secu

riti

es

Envi

ron

men

tal

Mat

eria

ls

Tech

Soft

war

e

Inte

rnet

gam

ing Oil

Jul 6, 2016

9

2H16 Market Outlook

including the government’s Internet Plus strategy for traditional industries. Meanwhile, new business models continue to develop and their monetization will continue to provide bright spots for industry players, especially for industry leaders in this “first take all” sector.

Figure 25: Fingerprint recognition penetration Figure 26: Internet game platform market size

Sources: Fingerprint Cards (FPC), GF Securities (HK) Sources: Analysys, GF Securities (HK)

Software The software sector continues to grow steadily in China, with demand for software

services growing rapidly. Continued technological innovation, enterprise cloud services, the mobile sector, artificial intelligence, and virtual/augmented reality are injecting necessary growth drivers for the sector. High growth is expected for applications in traditional industries such as financials, healthcare, education and agriculture as they will strengthen IT levels and business upgrades. Media Cinema-going is still at an early stage in China, with income from cinema movies expected

to grow at a CAGR of 31% over the next two years. As movie watching is more popular among the younger generations, the overall slowdown in consumer spending is likely to exert minimal pressure on demand for movies. Moreover, market demand is expected to move the value chain towards higher end movie configurations where penetration remains very low.

Figure 27: Software and IT service income and profit Figure 28: Income from cinema movies in China and the US

Sources: MIIT, GF Securities (HK) Sources: entgroup, GF Securities (HK)

Defensive sectors

Stable income We expect consumer staples to continue to be supported by growing income levels

and upgrades given relatively inelastic demand, while lower input costs will help to protect profit margins. Leading players will continue to command economies of scale and advantages in brand equity. Meanwhile, although the healthcare sector is seeing slower growth than in previous years

given stringent control on health insurance expenses and slow progress in drug tendering, we believe a sector re-rating is possible after the completion of provincial tendering, which should be by the year-end. We prefer companies with strong R&D capability, a large number of drugs that can mitigate against pricing pressure from tendering, and own products with high entry barriers.

10.8 11.49.8

6.64.5

2.23

59

12

0

2

4

6

8

10

12

14

16

18

2014 2015 2016F 2017F 2018F

Mobile phones equipped with fingerprint scanners (100m units)

Mobile phones not equipped with fingerprint scanners

47 55 58 58 58 58 58

10

1722 24 24 24 24

5

14

29

5464 69 70

0

20

40

60

80

100

120

140

160

2012 2013 2014 2015 2016E 2017E 2018E

Installed PC games revenue PC browser games revenue

7,573 9,970

13,588

18,849

24,794

30,587

37,026

42,848

912 1,341 2,174 2,796 3,366 3,831 4,826 5,766

12.0% 13.4%16.0% 14.8% 13.6% 12.5% 13.0% 13.5%

47.0%

62.2%

28.6%

20.4%13.8%

26.0%

19.5%

0%

10%

20%

30%

40%

50%

60%

70%

-

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

Revenue (Rmb100m) Profit (Rmb100m) Profit margin Profit growth

1.62.1

2.73.5

4.7

6.8

8.7

11.7

31%29% 30%

34%

45%

28%

34%

-4%

6%

1%

-5%

3% 3% 3%

-10%

0%

10%

20%

30%

40%

50%

0

2

4

6

8

10

12

14

2010 2011 2012 2013 2014 2015 2016E 2017E

China box office (US$ bn) US box office (US$ bn)

China box office growth US box office growth

Jul 6, 2016

10

2H16 Market Outlook

High yield Given the slim chance of an interest rate hike in the US in the next six months, interest in high yield investment products will remain high, in our view. Utilities such as telecoms and power

companies (in particular Hong Kong power companies) with stable cash flows are likely to maintain their high dividend payouts, providing decent dividend yields. Given stable rental income from commercial property and high dividend payout ratios, we believe REITs will remain a popular choice

for those seeking high yields. Policy beneficiaries

While investment driven policy to maintain high growth is no longer in place, we believe fixed asset investment will be targeted to specific industries where the government wishes to prioritise development, among which we believe transport infrastructure, environmental protection and new energy will remain the prioritised sectors over the next few years. According to the 13th Five-Year Plan, railway investment is projected at Rmb3.5-3.8trn in the five years to 2020, representing steady growth, of which inter-city high speed trains and intra-city trams are bright spots. With a growing railway network and railway equipment entering a replacement cycle, maintenance and upgrade demand will rise, leading to an estimated 13.9% CAGR in demand growth for railway equipment

during 2016-2020, faster than the 5% projected for railway construction. According to the 13th Five-Year Plan, environmental protection investment will increase to Rmb2trn, up from Rmb957.6bn

in 2014, representing 2.2% of GDP, up from 1.5%. The Ministry of Finance is speeding up the third batch of Public-Private Partnership (PPP) projects, and the focus will extend from water treatment and air pollution control to soil protection. Companies with exposure to these areas are likely to benefit most. In the new energy sector, the National Energy Administration is targeting 18.1GW of

solar power farm investment in 2016, up from 15.1GW in 2015. Downstream solar power farms are expected to increase utilization following the announcement of protective purchases of solar and wind power by the Chinese government to promote clean energy. Likewise, wind power plants will see the full-year benefit from the lowering of interest rates since Nov 2014, on top of rising utilization hours following the announcement of protective purchases.

Figure 29: China railway investment Figure 30: China environmental protection investment

Sources: NDRC, GF Securities (HK) Sources: MEP, GF Securities (HK)

Figure 31: Solar power plant capacity Figure 32: Polysilicon price

Sources: NEA, GF Securities (HK) Sources: NDRC, MEP, GF Securities (HK)

Rail investment in China

Rmb100m

Environmental protection investment in China (Rmb bn)

Environmental protection investment as % of GDP

Cumulative solar power installed capacity (GW)

Newly installed solar power capacity (GW)

Average polysilicon price (US$/kg)

YoY chg

Jul 6, 2016

11

2H16 Market Outlook

Figure 33: China wind power capacity Figure 34: China wind power utilization hours

Sources: NEA, NDRC, GF Securities (HK) Sources: NEA, NDRC, GF Securities (HK)

Stock picks We have compiled a ten-stock watchlist using a combination of top-down and bottom-

up approaches, integrating our investment strategy as described above.

Figure 35: Ten-stock watchlist

Sources: GF Securities (HK)

Figure 36: Valuations


Cumulative wind power installed capacity (GW)

Newly installed wind power capacity (GW) Utilization hours

Company Ticker Highlights

Tongda 698 HK Strong growth from Huawei and Xiaomi, growing popularity of metal casings

Chinasoft 354 HK Tier-one clients, JointForce platform online transformation

IMAX China 1970 HK High-end cinema platform to take advantage of rising movie revenue

Tencent 700 HK Industry leading internet giant with ample new business monetization opportunities

Geely Auto 175 HK Strong growth in sedans and growing edge in SUVs, aggressive NEV strategy

CSPC Pharm 1093 HK Wide variety of products ensuring flexible tendering strategy, strong R&D

Haitong International 665 HK Proven record in SH-HK Connect, potential beneficiary of SZ-HK Connect and QDII2

Huaneng Renewables 958 HK Policy support, rising utilization, lowering financing cost

CT Environmental 1363 HK High earnings growth and visibility, winner in the new soil protection policy

Hengan 1044 HK Stable earnings, gross margin to edge up on lower costs and product upgrades

Company Ticker Rating Stock price 16E P/E 17E P/E 16E dividend yield

(HK$) (x) (%) (%)

Tongda Group 698 HK Buy 1.51 8.8 19.3 4.0

Chinasoft International 354 HK Buy 3.02 17.0 24.3 0.0

IMAX China 1970 HK Accumulate 38.10 29.4 27.5 0.0

Tencent 700 HK Unrated 176.10 33.7 28.2 0.3

Geely Auto 175 HK Accumulate 4.19 10.2 22.9 1.2

CSPC Pharma 1093 HK Buy 6.90 20.0 21.4 1.9

Haitong International 665 HK Accumulate 4.65 11.9 28.2 3.5

Huaneng Renewables 958 HK Unrated 2.57 9.6 19.6 1.7

CT Environmental 1363 HK Unrated 2.24 16.7 18.3 1.2

Hengan Group 1044 HK Unrated 64.70 17.8 5.3 3.5

Jul 6, 2016

12

2H16 Market Outlook

Rating definitions Benchmark: Hong Kong Hang Seng Index Time horizon: 12 months

Company ratings

Buy Stock expected to outperform benchmark by more than 15%

Accumulate Stock expected to outperform benchmark by more than 5% but not more than 15%

Hold Expected stock relative performance ranges between -5% and 5%

Underperform Stock expected to underperform benchmark by more than 5%

Sector ratings

Positive Sector expected to outperform benchmark by more than 10%

Neutral Expected sector relative performance ranges between -10% and 10%

Cautious Sector expected to underperform benchmark by more than 10%

Analyst Certification The research analyst(s) primarily responsible for the content of this research report, in whole or in part, certifies that with respect to the company or relevant securities that the analyst(s) covered in this report: (1) all of the views expressed accurately reflect his or her personal views on the company or relevant securities mentioned herein; and (2) no part of his or her remuneration was, is, or will be, directly or indirectly, in connection with his or her specific recommendations or views expressed in this research report.

Disclosure of Interests (1) The proprietary trading division of GF Securities (Hong Kong) Brokerage Limited (“GF Securities (Hong Kong)”) and/or its affiliated or associated companies do not hold any shares of the securities mentioned in this research report. (2) GF Securities (Hong Kong) and/or its affiliated or associated companies have compensation or mandate for investment banking services received within the preceding 12 months from one of the companies, namely Haitong International Securities Group Limited (Stock Code: 665) (“Haitong International”) contained in this research report. GF Securities (Hong Kong) and/ or its affiliated or associated companies have acted as one of the Joint Bookrunners of Haitong International within the preceding 12 months. GF Securities (Hong Kong) and/or its affiliated or associated companies may receive compensation or mandate for investment banking services from the company in the future. In this connection, investors shall aware that conflict of interest may arise as the objectivity of GF Securities (Hong Kong) in this research report may be affected. (3) Neither the analyst(s) preparing this report nor his/her associate(s) serves as an officer of the company mentioned in this report and has any financial interests or hold any shares of the securities mentioned in this report.

Disclaimer This report is prepared by GF Securities (Hong Kong). It is published solely for information purpose and does not constitute an offer to buy or sell any securities or a solicitation of an offer to buy, or recommendation for investment in, any securities. The research report is intended solely for use of the clients of GF Securities (Hong Kong). The securities mentioned in the research report may not be allowed to be sold in certain jurisdictions. No action has been taken to permit the distribution of the research reports to any person in any jurisdiction that the circulation or distribution of such research report is unlawful. No representation or warranty, either express or implied, is made by GF Securities (Hong Kong) as to their accuracy and completeness of the information contained in the research report. GF Securities (Hong Kong) accepts no liability for all loss arising from the use of the materials presented in the research report, unless is excluded by applicable laws or regulations. Please be aware of the fact that investments involve risks and the price of securities may be fluctuated and therefore return may be varied, past results do not guarantee future performance. Any recommendation contained in the research report does not have regard to the specific investment objectives, financial situation and the particular needs of any individuals. The report is not to be taken in substitution for the exercise of judgment by respective recipients of the report, where necessary, recipients should obtain professional advice before making investment decisions. GF Securities (Hong Kong) may have issued, and may in the future issue, other communications that are inconsistent with, and reach different conclusions from, the information presented in the research report. The points of view, opinions and analytical methods adopted in the research report are solely expressed by the analysts but not that of GF Securities (Hong Kong) or its affiliates. The information, opinions and forecasts presented in the research report are the current opinions of the analysts as of the date appearing on this material only which may subject to change at any time without notice. The salesperson, dealer or other professionals of GF Securities (Hong Kong) may deliver opposite points of view to their clients and the proprietary trading division with respect to market commentary or dealing strategy either in writing or verbally. The proprietary trading division of GF Securities (Hong Kong) may have different investment decision which may be contrary to the opinions expressed in the research report. GF Securities (Hong Kong) or its affiliates or respective directors, officers, analysts and employees may have rights and interests in securities mentioned in the research report. Recipients should be aware of relevant disclosure of interest (if any) when reading the report. Copyright © GF Securities (Hong Kong) Brokerage Limited. Without the prior written consent obtained from GF Securities (Hong Kong) Brokerage Limited, any part of the materials contained herein should not (i) in any forms be copied or reproduced or (ii) be re-disseminated. © GF Securities (Hong Kong) Brokerage Limited. All rights reserved. 29-30/F, Li Po Chun Chambers, 189 Des Voeux Road Central, Hong Kong Tel: +852 3719 1111 Fax: +852 2907 6176 Website: http://www.gfgroup.com.hk

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