- Certain sub-sectors within Chinese Internet appear to be forming a longer-term bottom.
- Companies (such as Tencent) that were first to respond to China’s Common Prosperity plans are likely to be viewed more favorably.
- I am cautiously optimistic that we have arrived at a long-term bottom for specific names in the Chinese Internet sector’s KWEB ETF.
- Investor positioning in Chinese Tech Stocks is very light and any positive developments can quickly change sentiment.
Have Chinese Internet Stocks bottomed?
That is the million dollar question for China bulls. It’s worth looking at the KraneShares CSI China Internet ETF which includes some of the largest Chinese Internet stocks such as Alibaba, Tencent, and Meituan that serve as proxies for the overall sentiment of the Chinese tech sector.
In this research piece, I hope to share my thoughts on whether Chinese internet stocks have bottomed and, if so, which sub-sector seems to be poised for a more swift rebound. Along the way, I wish to share my thoughts on several key names in the KWEB ETF, namely Alibaba, JD.com, Pinduoduo, and Tencent. I believe these four names give us a powerful insight into the changing sentiment towards the Chinese Internet Sector.
Was this the bottom? To answer this question directly, I do think that certain sub-sectors may have found a bottom or are in the process of a bottoming phase. The challenging part is to find the specific names that are likely to see a larger recovery so that our capital is allocated correctly.
In order to fully explore this question, I will combine a fundamental approach and data-driven approach to answer this question. I will be revisiting my thinking process, which was a few trading sessions before Alibaba made a dramatic bounce from $152 and when KWEB bounced from $44. I mention Alibaba specifically because it is the proxy for general sentiment surrounding the Chinese Internet Sector and one of the largest holdings in KWEB along with Tencent.
My general opinion of the overall Chinese Internet Sector looks like this:
- Chinese educational stocks: I think that fundamentals have structurally changed and I think that any pivot in their business models at best will 2x their prices over a longer period of time. However, for the risk that investors take with this group, they potentially have the largest return IF they can pivot successfully. Key word is IF.
- E-Commerce stocks like Alibaba and Pinduoduo: I believe that there could be additional near term weakness but I do not share the concerns of VIE listing issues or delisting issues. However, the upside is now a bit constrained and I’m going to walk you through my analysis of why that might be the case.
- General internet companies like Tencent and Bilibili for gaming and other services: I actually do think the bottom is close, and I believe this category has the most stability going forward.
The main principle to remember is that the core drivers of growth tech stocks include the 1.) earnings growth outlook and 2.) the expectations of earnings sustainability.
As a reminder, even with companies that are mired in political drama, growth tech stocks will continue to follow the principles of aligning with the earnings growth outlook and any expectations of earnings sustainability. Any company that can satisfy these two simple yet important perspectives will be rewarded with a higher valuation multiple. Even though this seems like an oversimplification, given the political landscape in China currently, assessing the outlook and earnings sustainability of Chinese companies at this time is no easy task.
At this moment, it seems that Chinese Internet stocks are going through a period of re-rating, and as a result while a longer term bottom could be forming, we might go through a consolidation phase before enthusiasm returns to this sector. As with any sector, any industry or stock gets re-rated as the expectations for its growth outlook of earnings sustainability changes. That’s exactly what is happening to Chinese stocks now. I believe most companies are getting re-rated based on the new regulatory landscape, and we’ll dive into specific metrics in a moment.
So specifically for the E-Commerce Sector, for BABA, JD and Pinduoduo, it’s likely that the long-term earnings and margin outlook will moderate because of a couple factors such as:
- More competition and enforcing anti-monopolistic behavior, which creates friction in market share gains.
- More constraints on data collection, which makes targeting of consumers more difficult.
- More socialism oriented practices such as engaging in Common Prosperity, which by the way I think is a very positive development for China. In this category, it takes away opportunities for higher end products, while companies that serve the middle class such as Alibaba and Meituan may actually benefit.
Now, for each stock I mentioned, I believe they each trade according to specific metrics.
Alibaba: How the Street thinks about BABA
For Alibaba, many institutional investors use the forward P/E ratio and that makes a lot of sense because it has had historical earnings sustainability and growth. The way institutional investors have traditionally valued Alibaba is by the Sum-of-parts valuation or by a simple P/E ratio or forward P/E ratio.
Looking at Alibaba’s P/E ratio over time can help understand the peaks and valleys of its valuation; in other words, when has it been most or least expensive from a valuation perspective. As of today’s prices, the estimated forward P/E is around 17x earnings.
This valuation is at its lowest point since 2016 when Alibaba’s forward P/E was also 18x during a time when its e-commerce business was slowing down and its new initiatives had not yet been profitable, which ended up producing quarters that missed Wall Street expectations.
Given that most Wall Street Analysts have a price target for Alibaba at $270, many analysts are likely using the sum of the parts valuation (SOTP). From a SOTP valuation using consensus figures, it’s estimated that the Core Commerce business is worth $160/share, their cloud computing service is worth $48/share, media and entertainment is worth $8/share, $35/share for equity investments, and $18/share just for net cash. That’s how they arrive at their price target of $270.
Given that Alibaba is trading at a significant discount to these price targets, I would say that the core commerce business is being heavily discounted by the market due to increasing competition. In addition, I think the cloud computing service is being discounted because of data privacy. Because of these concerns, I think the multiples could be too high and what Cathie Wood said in late July was accurate for that specific period in that valuations are going to go down, and probably remain down.
However, sentiment seemed to have changed after this past week’s monster rally as Cathie Wood is back in the game by entering JD. And JD is the name which I will talk about next.
JD: How the Street thinks about JD
For JD, before it was profitable in 2017, investors used to use the Price to sales multiple to value JD. Now as the company has matured, institutional investors use a combination of sum-of-the-parts and traditional P/E ratio to value JD.
If you are familiar with JD, you may know that back in 2018, all of its important metrics such as user and revenue growth along with margins were all under pressure without any immediate sign of improvement. Contrast that with today where the current outlook is much more positive, and it’s very difficult to use the peak and valley valuation to understand JD.
Instead, what we can do is look at the last 5 years of revenue growth, last year’s net income margin, and assume a traditional P/E of 15x for a conservative measure, the result is that JD’s current share price is significantly above its floor value because there’s less regulatory risk. JD faces less risk because its business is considered to have more compliant practices such as having fewer issues with re-allocating benefits from the platform and merchants (which is something Alibaba has a big control over). And also they hire all of their delivery staff rather than outsource, which means they would avoid any major issues that DiDi is going through right now.
This explains why JD’s stock price has been relatively more resilient compared to Alibaba. And in fact, their latest bounce that we saw from this week has been more durable than Alibaba’s because the lingering concerns are not as demanding on its business model.
In my opinion, JD represents one of the more rational investments currently in the Chinese Internet sector as it appears the share price is trading more alongside its fundamentals with a relatively lower reliance on political sentiment.
PDD: How the street thinks about Pinduoduo
Most investors do not follow Pinduoduo as closely, because it’s less well known outside of China and fewer retail investors talk about PDD. But I’ll offer a quick summary of my thoughts on PDD because it is essential to the e-commerce sector in China. The company is the largest agricultural focused tech platform in China. Its platform connects farmers and distributors with consumers directly through its interactive shopping experience. As China rapidly evolves from an emerging market into a developed market, PDD’s business model becomes central to their development.
Until recently, PDD has been a momentum stock without positive earnings so traditional growth metrics such as P/S have been used to understand the company. In brief, I think PDD’s share price action has shown that e-commerce is continuing to meet expectations, and that the market is not being overly irrational.
The share price was rewarded after beating expectations this latest quarter, highlighting the fact that while regulatory issues are a major drag, it is the earnings OUTLOOK and the earnings sustainability that drives the price. In addition, PDD appears to be another clue into how traders are giving credit to Chinese companies that are aligning with the Common Prosperity theme.
In my opinion, investors should not worry about companies donating a significant portion of their profits towards the Common Prosperity goal in China. In fact, I believe companies that are acting “too much” in shareholder interests and attempting to maximize their profits are ironically a short-sale candidate. I believe Chinese companies that do not align with China’s long-term vision for society will eventually be imposed with fines that would make it harder for them to operate anyway.
Pinduoduo demonstrated that making significant contributions towards Common Prosperity gives it more runway to continue expanding its current business model without excessive backlash from China.
Tencent: the key proxy for a sustainable rebound in Chinese Internet
Lastly, I believe that the most important part of understanding China’s Internet Sector rebound will depend on Tencent. That is because Tencent has an outsized influence on major Chinese listed ETFs. Tencent holds the largest weighting in CQQQ and in KWEB. As a result, together with Alibaba, they have the ability to drive sentiment for the entire sector.
I would say that in this environment, Tencent, Alibaba, Meituan, and Baidu (in that order of importance) are equivalent to the U.S. FAAMG companies in terms of importance in driving the overall Chinese tech sector.
However, in my personal opinion, I do think that Tencent has more relative potential than Alibaba because its business model is more versatile and global. They are focusing on helping companies pursue digital transformation through their Business Services segment. They have an ads business and also a fintech business. Perhaps the most exciting segment that they are building out is innovating their online gaming segment with high-production games with global appeal in the long term.
If you’ve been following Facebook, you might know that Mark Zuckerberg is more excited than ever about the future of the “Metaverse” which he calls the final form of computing. The metaverse is a collective virtual shared space which is the sum of all worlds, virtual reality, augmented reality and the internet. Tencent is building out its scale for teams to develop metaverse-level games in the future, which is going to be a total addressable market that will be very large in the future due to the interesting nature of this area.
While that of course is a long-term goal, in the near term, Tencent’s gaming revenue is likely to be stable as they pursue more users outside of China. Tencent’s stable business model implies that we can use the P/E ratio or sum of the parts model to value it. Just like Alibaba’s shares, Tencent is trading at near the lowest PE of 22x earnings in the past 5 years.
I do believe that its growth prospects in all of the verticals it is pursuing makes it eventually merit a higher PE than 22x since most growth stocks trade north of 30x in the global tech space. And also, Tencent is now donating over $7billion in social aid for a common prosperity fund to build better relationships with Chinese officials. This development is absolutely key because Tencent was one of the first companies to contribute towards the Common Prosperity plan, which keeps them in good standing compared to companies that unwisely acted later.
My order of preference within the Chinese Internet Sector
My order of preference and opinion on the recovery time frame work out like this.
Shorter-term, I believe Tencent and related streaming stocks like Bilibili along with JD are best positioned to recover faster. Tencent because of their diversified business model and their first mover decision to support Common Prosperity along with their prompt response to government regulation. JD because of its business model being less impacted by regulation.
In the medium term, I do think Alibaba and PDD will make a bounce-back. It will simply take several quarters for earnings and fundamentals to remind investors that their business models are still sound despite the impact of regulation on their companies.
And finally in the long term, I do think that the Chinese Educational sectors EDU and TAL will survive. This category has the highest return potential because if a pivot is successful, then a new narrative is written, but also the greatest risk and uncertainty. So size positions accordingly.
However, one risk that I’m looking out for is when they will have their latest earnings release. The longer that earnings release or any company update is postponed, the longer it will be before we see a structural snapback.
Have we bottomed in the Chinese Internet space? If so, why choose KWEB ?
So have Chinese stocks bottomed? I do think the answer is yes for certain sub-sectors. However, developments can change my opinion quickly, so it is important to note that this opinion is based on information up until today. For most investors who are unable to dedicate the time to research the nuances of each company in the Chinese Internet sector, I believe the KWEB or CQQQ ETFs give investors broad exposure to this sector. In addition, given that it is potentially difficult to find the specific companies that are likely to outperform in this constantly changing regulatory environment, sometimes an ETF such as KWEB can give investors broad exposure to any continued recovery.
The KWEB ETF does include Tencent, Alibaba, JD, Meituan, and Pinduoduo as the largest 5 holdings, so you do have to have a reasonably positive outlook on these three names before entering a position because they contribute nearly 50% of this ETF’s weight.
The capitulation of KWEB along with other stocks in this index has been surprisingly swift. Within a matter of two weeks, the KWEB ETF has bounced 20% from its recent lows of $44 and now trades above $52. I do think that we are entering a bottom phase; however, those of us who purchased at the lows now enjoy a far greater margin of safety than investors chasing the rebound.
Personally, I am holding tight to KWEB after my recent purchases and I don’t intend to add more to this rebound, but it appears risk appetite could be returning faster than expected. Good luck to all. More investment research to come.
Author: Larry Cheung, CFA, Seeking Alpha