February 7, 2012

ASIA-PACIFIC PACIFIC EQUITY Investment Research

DMG & Partners Research STRATEGY
Craig Irvine Chief Regional Strategist +65 6232 3894 craig.irvine@sg.oskgroup.com

Asia Asia-Pacific

Private Circulation Only

THE INTERESTING TIMES

Raising China Index Target
Action Summary

No 8

We are raising our HSCEI index target to 13,500 (from 12,300, up 10%) 10%). The change reflects our growing conviction that risk pricing will pull back by at least 150bps over the next 12 months. Earnings have compounded at 19% over the last ten years. Hence, assuming a 9.0% long term growth rate (as we do in our fair value estimates) ) already discounts a significant earnings slowdown. Fair value is now much more sensitive to risk pricing than to long term growth. Assuming a 2pps (from 9.0% to 7.0%) reduction in long term growth implies just 6% lower fair value. Our favorite sectors are banks, domestic infrastructure and selected resource stocks.

Figure 1: Recommended Country Weightings, Regional Portfolio

Source: Bloomberg Bloomberg, OSK/DMG estimates

Raising our Index Target for China

We are raising our 12m index target for the HSCEI from 12,300 to 13,500 (+10%). We believe the China country risk premium will fall by at least 150bps over the next twelve months. The risk premium has climbed by over 400bps DMG & Partners Securities Pte Ltd may have received compensation from the company covered in this report for its corporate finance or its dealing activities; this report is therefore classified as a non-independent non independent report. Please refer to important disclosures at the end of this publicatio publication. DMG Research
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since the start of the Eurozone crisis, which we think is overdone. If risk premiums fall further, upside w would be even greater. Fair Value: Our Approach Our primary fair value approach is based on the relationship: P / E = (ROE g) / (ROE x (k g)) where: g = long term growth rate k = cost of equity China presents a challenge here, because average earnings growth of 23% over the last decade has been significantly higher than the cost of equity or ROE. Our model breaks down at very high growth rates. So we assume a more conservative but still very strong long term growth rate of 9.0%. While W significantly below the recent averages, we believe this is prudent. China Premium to Re Re-emerge The HSCEI has historically traded at a material premium to our fair value estimate, as shown in Figure 2 below. We attribute this to extraordinarily hig high earnings growth growth, , and to some periods of excessive optimism (2007) and high liquidity (2009). In the second half of 2011, however, the HSCEI fell to a discount to fair value, reflecting extreme risk pricing conditions brought on by the Eurozone crisis. China valuations have been affected more in this respect than the rest of Asia.

Figure 2 2: HSCEI: Index Level v Fair Value

Extreme outliers have been left off the fair value curves shows. Source: Bloomberg, OSK/DMG estimates

As we have written previously, we expect a fall in risk premium to restore the premium over the next 12 months. Specifically, we expect at least of 150 bps reduction by the end of 2012.

Components of Our Fair Value Estimates

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It is worthwhile to break down the individual components of our fair value model to test for consistency and reasonableness. We conclude that xx of the key components of fair value either stable or are more likely to get better than worse. ROE: K: LTG: EPS: Expect slight dip below 20%, but comfortably above k. Country risk premium has expanded, expect retracement. Fair value not very sensitive to slower LTG assumption. Weakest short term link. Expect big downward revisions in March potential buying opportunity?

ROE: : Stable and Comfortably Higher than Cost of Equity Except during the global financial crisis, ROE for large cap China stocks has been consistently around 20% since 2005. Consensus ROE estimates dip slightly in the next two years to 18.0% in 2012E and 17.8% in 2013E but still comfortably above the cost of equity (around 15%).

Figure 3 3: HSCEI ROE and Cost of Equity

Source: Bloomberg, OSK / DMG estimates

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Cost of Equity (k): (k): Lots of Room for Risk Premium to Fall Though the long term cost of equity for China has been relatively stable, volatility in this measure has increased significantly in the last two years. Previously, risk free rates were higher, but risk premiums were lower. Now (since the Eurozone crisis), the risk free rate is very low, but ri risk sk premium has spiked up by o over 400bps, as shown in Figure 4 below. We think this spike is overdone. Figure 4 4: Country Risk Premium: China

Source: Bloomberg, OSK/DMG estimates

Long Term Growth (g) (g): Our Assumption is Well Below 10 Year History Estimating the appropriate long term growth rate is probably the trickiest part of the fair value estimate for China. Earnings growth has averaged 23% and has compounded at 19 19% p.a. over the last decade. . The trend is slowing slightly, but still significa significantly ntly above levels that are prudent to assume for the long term. We assume a LTG of 9.0%. This is less than half of the last decades CAGR of 19%, and in line with GDP growth estimates for the forseeable future. Figure 5 5: HSCEI EPS Growth, w/ Average and Trend Line

Source: Bloomberg

Implied LTG and k: Greater Sensitivity to Cost of Equity

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Interestingly, our fair value estimate is now far more sensitive to the cost of equity than to the LTG assumption. The market is currently implying a long term growth rate of around 9.0% and a CRP of around 13.5%. As shown in the Figure 6 below, assuming a lower CRP implies a significantly higher change to fair value than moving assuming a lower LTG rate. This is at least partly due to the LTG assumption already being significantly below current EPS growth rates for the market. We think this represents a degree of downside protection. At constant risk pricing (already near an all time high), 200bps slower structural structura growth would only reduce fair value by 6%, while a 100bps reduction in risk pricing translates to 18% upside.

Figure 6: Fair Value Sensitivity to LTG and CRP LongTermGrowthRate CRP 10.5% 11.5% 12.5% 13.5% 14.5% 15.5% 5.0% 14,690 12,942 11,566 10,454 9,538 8,769 7.0% 16,971 14,321 12,387 10,913 9,753 8,816 9.0% 21,932 16,953 13,816 11,659 10,085 8,885 11.0% 41,018 23,962 16,924 13,082 10,661 8,997

Source: Bloomberg, OSK/DMG estimates

See important disclosures at the end of this publication

Table 1: Recommended Weightings, Asia (ex Japan)

Index China (26.9 / 34.9) Hong Kong (19 / 17) Korea (14.2 / 12.2) Taiwan (10.2 / 6.2) India (8.7 / 8.7) Indonesia (5.6 / 8.6) Singapore (5.6 / 3.6) Thailand (4.1 / 3.1) Malaysia (3.9 / 3.9) Philippines (1.7 / 1.7)
* Excluding HSCEI stocks
Source: Bloomberg, OSK / DMG estimates

Level 11,565 1,973 7,688 17,707 3,975 2,940 1,094 1,539 4,816

Target 13,500 16,250 1,700 5,000 16,000 4,450 3,022 1,000 1,466 4,200

Upside 16.7% -21.5% -13.8% -35.0% -9.6% 11.9% 2.8% -8.6% -4.7% -12.8%

Regional Wgt 26.9% 19.0% 14.2% 10.2% 8.7% 5.6% 5.6% 4.1% 3.9% 1.7% 100%

Rec Wgt 34.9% 17.0% 12.2% 6.2% 8.7% 8.6% 3.6% 3.1% 3.9% 1.7% 100%

Over/ Under 30% -11% -14% -39% 0% 54% -36% -24% 0% 0%

PPS 8.0 (2.0) (2.0) (4.0) 3.0 (2.0) (1.0) -

HSCEI KOSPI TWSE SENSEX JCI STI SET KLCI PCOMP

HSI (adj)* 20,710

Table 2: Market Valuation Ratios

6-Feb-12 China Hong Kong Indonesia Malaysia Singapore Thailand Philippines India Taiwan Korea USA Europe

ROE 2011 2012 18.0% 16.9% 28.8% 22.7% 0.9% 22.6% 19.1% 24.2% 15.7% 15.2% 28.4% 14.0% 17.8% 16.9% 28.3% 25.5% 3.2% 23.4% 20.1% 23.7% 15.3% 15.2% 31.9% 14.3%

P/B 2011 1.7 1.5 2.9 2.3 1.4 2.1 2.7 2.8 1.7 1.2 2.2 1.2

PE 2011 9.6 9.4 17.6 16.9 8.6 14.2 17.3 16.1 17.6 19.9 14.0 12.2 2012 8.6 10.5 13.5 14.3 13.7 11.6 14.7 15.7 13.9 9.6 12.8 9.6

Yield FCF Yld 2011 2011 2.8% 3.3% 2.0% 3.4% 3.7% 3.9% 3.0% 1.5% 4.3% 0.8% 2.0% 4.7% 3.6% 5.3% 1.5% -2.8% 3.8% 7.5% 6.1% 1.7% 3.6% 2.5% 8.1% 3.7%

EPS Growth 2012 2013 12.2% -10.7% 30.7% 17.7% -37.4% 23.2% 17.8% 2.7% 26.6% 108.8% 9.0% 28.0% 12.5% 12.0% 17.3% 10.6% 11.9% 13.5% 12.4% 14.3% 19.5% 16.3% 12.7% 10.1%

Source: Bloomberg, OSK/DMG estimates

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DMG Research

DMG & Partners Research Guide to Investment Ratings Buy: Share price may exceed 10% over the next 12 months Trading Buy: Share price may exceed 15% over the next 3 months, however longer-term outlook remains uncertain Neutral: Share price may fall within the range of +/- 10% over the next 12 months Take Profit: Target price has been attained. Look to accumulate at lower levels Sell: Share price may fall by more than 10% over the next 12 months Not Rated: Stock is not within regular research coverage DISCLAIMERS This research is issued by DMG & Partners Research Pte Ltd and it is for general distribution only. It does not have any regard to the specific investment objectives, financial situation and particular needs of any specific recipient of this research report. You should independently evaluate particular investments and consult an independent financial adviser before making any investments or entering into any transaction in relation to any securities or investment instruments mentioned in this report. The information contained herein has been obtained from sources we believed to be reliable but we do not make any representation or warranty nor accept any responsibility or liability as to its accuracy, completeness or correctness. Opinions and views expressed in this report are subject to change without notice. This report does not constitute or form part of any offer or solicitation of any offer to buy or sell any securities. DMG & Partners Research Pte Ltd is a wholly owned subsidiary of DMG & Partners Securities Pte Ltd, a joint venture between OSK Investment Bank Berhad and Deutsche Asia Pacific Holdings Pte Ltd (a subsidiary of Deutsche Bank Group). DMG & Partners Securities Pte Ltd is a Member of the Singapore Exchange Securities Trading Limited. DMG & Partners Securities Pte Ltd and their associates, directors, and/or employees may have positions in, and may effect transactions in the securities covered in the report, and may also perform or seek to perform broking and other corporate finance related services for the corporations whose securities are covered in the report. As of the day before 7 February 2012, DMG & Partners Securities Pte Ltd and its subsidiaries, including DMG & Partners Research Pte Ltd, do not have proprietary positions in the subject companies, except for: a) Nil b) Nil As of the day before 7 February 2012, none of the analysts who covered the stock in this report has an interest in the subject companies covered in this report, except for: Analyst Company a) Nil b) Nil DMG & Partners Research Pte. Ltd. (Reg. No. 200808705N) Kuala Lumpur
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