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