Cost of capital, Sea earnings, and step premium in Chinese equities

Equities 7 minutes to read
Peter Garnry

Head of Equity Strategy

Summary:  Rising interest rates have historically been associated with lower equity returns relative to when interest rates are falling. Interest rates impact equities through the discount rate on future cash flows and we discuss which parts of the equity market will be most impacted from rising interest rates. Sea, one of the world's fastest growing e-commerce businesses, reports Q4 earnings in US pre-market session and the numbers look strong on the top line although the company is experiencing a slowdown in its mobile gaming business. Finally, we discuss whether Chinese or global equities are most at risk being in a bubble given today's comments from China's banking regulator.


Rising interest rates have been the big story in financial markets the past two months. Right now, the debate is raging whether it is due to rising inflation expectations or rising growth expectations. The instruments typically used in the fixed income market to express inflation expectations are muted, but if we look across our equity theme baskets then it is obvious that rising inflation expectations are being expressed. Our commodity sector basket is up 15.7% YTD, but high growth parts of the market such as bubble stocks and e-commerce are also strongly bid suggesting growth expectations are strong and may be a big part of the move in interest rates.

Interest rates hit equities through the discount rate of future cash flows through both cost of equity and cost of debt. According to data since 1962 monthly median US equity returns are twice as high on months when the US 10-year yield is falling compared when yields are rising. Rising interest rates should subdue equity returns but not all segments will be equally hit. Highly debt financed industries such as telecommunication, infrastructure, utilities, capital goods, carmakers, shipping etc. will see a higher marginal change in their cost of capital from rising rates and thus should be more sensitive unless these industries can raise prices or see higher growth rates. Highly valued companies, such as our bubble stocks basket, have per definition a low implied equity risk premium and thus low cost of equity. Since many of them are mainly equity financed their sensitivity should in theory be much more sensitive to rising interest rates.

As we said the other day on our podcast, the forward free cash flow yield on the MSCI World Index is around 5.2% which compared to the risk-free rate suggests a 3.8% equity risk premium in steady state, which is in line with the historic average. In other words, we are not alarmed on the overall equity market from rising interest rates.

Sea shows strong Q4 growth but still losing money

Sea, which operates successful mobile games and a fast-growing e-commerce platform in Southeast Asia, reported Q4 earnings before the US market open. Q4 revenue is up 102% y/y while the operating loss increased further to $-357mn from $-282mn a year ago. While the e-commerce business is showing stellar growth rates the digital entertainment segment is seeing a dramatic slowdown in bookings q/q although still at a 7.2% growth rate q/q. The company has a third segment in financial services offering a mobile wallet and while numbers are impressive the financial income from this segment is negligible at this point.

Source: Sea Ltd Q4 2020 filing

The company has become cash flow positive from operations although the cash flow statements are so high level that we cannot see how they arrive at this figure. The company is not generating positive free cash flow yet due to high investing activity. Sea is good at raising capital with the combined capital raise in 2019 and 2020 at $6.31bn through a combination of debt and equity issuances. Coming back to the operating loss in 2020, it is interesting to observe that Sea is doing many accounting adjustments to show a positive adjusted EBITDA. They back deferred revenue and incentives net-offs from e-commerce into EBITDA. But both deferred revenue and incentives in e-commerce are natural parts of those businesses and should not be adjusted. While Sea has been a spectacular growth story there are still issues around their numbers and we would like to see the company raise its gross margin in the e-commerce business.

Which bubble is the biggest?

China’s banking regulator warned today of bubbles in not just the domestic property market but also in foreign equity markets. While there is clear evidence of frothy behaviour in global equity markets which we have covered endlessly the past year, we would argue that the potential equity bubble is larger in Chinese equities. The MSCI China Index has gone from being valued at a 20% discount in 2013 to almost 30% premium this year based on forward equity valuation multiple such as the EV/EBITDA. A combination of rising interest rates, a stronger USD and higher commodity prices could cause sentiment to sour in China and put upward pressure on global consumer prices as input costs would have to be covered by Chinese producers raising prices.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)
Full disclaimer (https://www.home.saxo/legal/saxoselect-disclaimer/disclaimer)

Saxo Bank (Schweiz) AG
Beethovenstrasse 33
CH-8002
Zürich
Switzerland

Contact Saxo

Select region

Switzerland
Switzerland

All trading carries risk. Losses can exceed deposits on margin products. You should consider whether you understand how our products work and whether you can afford to take the high risk of losing your money. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. The KIDs can be accessed here or within the trading platform. Please note that the full prospectus can be obtained free of charge from Saxo Bank (Switzerland) ltd. or the issuer.

This website can be accessed worldwide however the information on the website is related to Saxo Bank (Switzerland) Ltd. All clients will directly engage with Saxo Bank (Switzerland) Ltd. and all client agreements will be entered into with Saxo Bank (Switzerland) Ltd. and thus governed by Swiss Law.

The content of this website represents marketing material and has not been notified or submitted to any supervisory authority.

If you contact Saxo Bank (Switzerland) Ltd. or visit this website, you acknowledge and agree that any data that you transmit to Saxo Bank (Switzerland) Ltd., either through this website, by telephone or by any other means of communication (e.g. e-mail), may be collected or recorded and transferred to other Saxo Bank Group companies or third parties in Switzerland or abroad and may be stored or otherwise processed by them or Saxo Bank (Switzerland) Ltd. You release Saxo Bank (Switzerland) Ltd. from its obligations under Swiss banking and securities dealer secrecies and, to the extent permitted by law, data protection laws as well as other laws and obligations to protect privacy. Saxo Bank (Switzerland) Ltd. has implemented appropriate technical and organizational measures to protect data from unauthorized processing and disclosure and applies appropriate safeguards to guarantee adequate protection of such data.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc.