Head of Equity Strategy
Summary: Our Chinese Consumer & Technology basket is the worst performing basket this year due to the ongoing technology crackdown in China. Many investors are asking us whether it is time to buy Chinese technology stocks. The short answer is no. Chinese technology stocks are currently trading at a discount to US technology stocks for good reasons and as long as this discount persists we think investors should focus on Chinese consumer stocks and get exposure to technology in the US. Finally, we take a look at Facebook and Tencent as both companies are pivotal for technology sentiment in the US and China.
In client conversations and follow-up questions to our presentations the single most asked question relates to Chinese technology stocks. Investors have for years bought the growth and technology story of China. The crackdown of the technology sector in China that started over a year ago has intensified this year with an onslaught against the for-profit education industry and the world’s toughest data privacy law. Gaming regulation and tighter control of content dissemination are on the way, and the word ‘Common Prosperity’ is being used more and more in government speeches indicating higher taxes and more redistribution; Alibaba recently announced that it expects to lose various preferential tax rates related to its various businesses. The regulatory shift in China has impacted our China Consumer & Technology basket so that it is now the worst performing theme basket year-to-date down 12.4%.
Sentiment has improved and Ark Invest is endorsing JD.com
Sentiment has recently lifted considerably from very low levels in Chinese technology stocks as large technology investors such as Cathie Wood has come back to Chinese technology stocks and companies such as JD.com delivered better than expected earnings on Monday. Yesterday, Pinduoduo posted its first quarterly positive net income and said that it would distribute $1.5bn in profits to Chinese farmers over time in line with the indirect wish of China under the ‘Common Prosperity’ principle. Today, Xiaomi and Kuaishou Technology have both reported stronger than expected earnings again bolstering the view that maybe regulation is here in voice but in terms of action the impact is minimal. Also, the PBOC has communicated that it is willing to support the Chinese economy and today the central bank intervened in the repo market, suggesting that China might soon loose its fiscal and monetary policy.
Echoing what we have been saying for a while, Cathie Wood explained in a Bloomberg interview yesterday, that investing in Chinese technology stocks in the future is about finding companies that are aligned with the strategic objectives of the Chinese government. That is why Ark Invest is now again investing in JD.com because they see it as a positive force in the Chinese society building out local logistics infrastructure. Likewise we have argued that companies such as Xiaomi and ANTA Sports are part of the consumer economy and a positive for the Chinese government. But one thing is consumer stocks in China another and much more importantly, is it time to technology stocks again?
The Party Congress and valuation discount
Before ploughing into Chinese technology stocks investors should recognise that China’s next Party Congress is set for October 2022 and thus the political sphere could continue to cast a shadow over the Chinese equity market. The main objectives for China are to clean the environment, reduce inequality, become self-reliant across key technologies such as semiconductors and renewable energy, and ensure that technology companies do not become too powerful reducing competition. That is the political dimension.
If we look at the 12-month EV/EBITDA valuation metric we can see that the Hang Seng Tech Index has gone from trading at a significant premium to discount relative to the Nasdaq 100 Index. Given the political uncertainty, delta variant in a zero-case policy framework, and financial leverage per Huarong and Evergrande, justifies a valuation discount for now in Chinese technology stocks. Our general view is that it will take time for foreign investors to come back and the “tail-risk” that has happened in Chinese technology stocks will not be easily forgotten by investors. As long as Chinese technology stocks trade at a discount to US technology stocks investors should focus on Chinese consumer stocks rather than technology stocks. For the short-term traders with a high risk tolerance going long Chinese technology stocks can be an option.
Tencent vs Facebook
Tencent is by far the most powerful private company in China together with Alibaba. Given Tencent’s share price is down 39% from the peak it is a natural question whether this is not a remarkable buying opportunity. Tencent is China’s largest social media platform and the best, not perfect, peer outside China is Facebook. While Tencent has emphasized gaming and recently payments to generate revenue on its platform, Facebook has focused on advertising moving up the ladder to large brand campaigns and allowed third-party providers to develop apps on the platform. Facebook is also considering a bigger move into both payments and gaming.
Tencent has for most of the time since Facebook’s IPO been trading at a valuation premium to Facebook. This premium has recently shrunk together with the general rout in Chinese technology stocks but the premium persists. But will it last? With foreign investors pulling out of China for now we cannot leave out the possibility that Tencent could suddenly trade at a discount to Facebook.
If we look at the numbers, Tencent is expected to grow revenue by 20% in 2021 and 19% in 2022, while Facebook is expected to deliver revenue growth of 39% and 20% in the same years respectively. Facebook is operating at 51.1% EBITDA margin while Tencent is at 31.4%. Both companies have roughly a 30% free cash flow generation from revenue. Facebook’s capex to revenue level is around 50% higher and Facebook spends 21.5% of revenue on R&D while Tencent spends only 8.1%. Facebook’s ROIC is 33% while Tencent’s is 27.2%. Facebook is also at risk of being heavily regulated and the future global corporate tax rate for multinational will negatively hit profits of Facebook.
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