Chinese Internet Stocks: Relief Rally Or The Start Of A New Dawn?

Investors were generally relieved by the news that U.S. lawmakers had reached a deal on a short-term debt ceiling extension effectively averting a possible government default for several months. Chinese stocks were lifted by a few other boosters, sending the representative ETFs of Chinese companies rallying and outperforming their U.S. counterparts for the third consecutive week.

The Invesco China Technology ETF (CQQQ) ended up 4.8 percent to lead the pack in an impressive comeback after finding itself at the bottom of the chart earlier in the week. The majority of its top ten holdings performed well last week.

Tencent Holdings, Meituan, and Baidu, the three Chinese internet giants fronting the CQQQ portfolio surged 7.4 percent, 10.6 percent, and 7.1 percent respectively. GDS Holdings, the seventh-largest component, gained 8.4 percent. Tencent Music Entertainment Group, the tenth-largest holding, jumped 9.9 percent.

The iShares China Large-Cap ETF (FXI) also did well, rising 3.1 percent higher. The FXI ETF, which also counts Tencent and Meituan as its top holdings, had already enjoyed a lift the previous week. Investors plowed back into the banking and insurance stocks which were among its largest holdings when it appeared that the embattled property developer Evergrande wasn’t going to be a disaster to the broader Chinese economy as pundits had envisaged.

The Xtrackers Harvest CSI 300 China A-Shares ETF (ASHR) gained a respectable 2.8 percent with a diversified portfolio. Kweichow Moutai Co Ltd, the top holding of the ASHR ETF, has rebounded 18.8 percent since its mid-August trough.

The agreement by U.S. President Biden and Chinese leader Xi Jinping to hold a virtual summit before the year-end was regarded as a major positive step in bilateral relations. This would go a long way to bolster investor confidence, even as hopes aren’t high for a breakthrough in several thorny issues between the two largest economies in the world.

Meanwhile, local analysts were expecting Chinese stocks to break out in the current calendar quarter as investors bet on relaxation in monetary policies and stronger fourth-quarter GDP growth.

Cheery macro data and developments are supporting the bullish narrative for Chinese equities

The Chinese population enjoyed a weeklong vacation dubbed the Golden Week holiday last week. The state media reported that tourism revenues in China during the break declined nearly 5 percent year-on-year, leading Reuters to churn out an article on Thursday with a bearish-sounding title – China’s soft Golden Week data bode ill for retail sales.

Judging by the stock market price action, it was apparent that few were sharing similar thoughts. Instead, with the rally, it seemed market players were largely tilting towards the optimism propagated by the domestic media. Some cited the 2021 National Day Golden Week Consumer Trend Report released by Meituan on October 6 that according to its internal data, the overall consumption on its platforms during this year’s National Day surged 29.5 percent compared with last year’s National Day.

Noteworthy, compared with the 2019 National Day, consumption on its platforms soared 51.6 percent. Meituan generated the consumption data from its myriad businesses in food delivery, catering, tourism, accommodation, entertainment, travel, etc. Investors are ostensibly getting better at uncovering contradictions.

On September 30, China’s State Administration of Foreign Exchange [SAFE] revealed that net flows of overseas investments into the country soared to a record high of $442.8 billion in the first half of the year. The huge capital inflows can be attributed to the favorable returns from yuan-denominated assets buoyed by the currency’s ongoing appreciation, as well as overseas investors’ rising confidence in the Chinese economy getting back on its growth track from the Covid-19 pandemic, even as some other countries continued to struggle in containing the fallout.

Indeed, Bloomberg reported on Friday that “millions of migrant workers in Vietnam could flee the country’s factory heartland.” It came days after an Al Jazeera article detailing the horrifying plight of starving migrant workers who had to go on their knees as they pleaded with the soldiers to allow them to exit Ho Chi Minh City, the COVID-19 epicenter of Vietnam, after authorities lifted a strict stay-at-home order.

Source: Bloomberg

The same Bloomberg news said “tens of thousands of staff” did not report for work at a Vietnamese unit of the largest producer of athletic shoes in the world, putting at risk its plans to return to full production next month. Ironically, due to the power outages in China in the past weeks, we also have more reports of businesses evaluating their over-reliance on China for their manufacturing needs.

Source: NIKKEI Asia

An executive at a speaker supplier in Dongguan, a city in southern China, revealed in an interview with NIKKEI Asia that his company was “again reopening our evaluations of overseas plants, perhaps in Vietnam…” Well, we have heard of this “story” many times before and know how it ended up.

After China swiftly contained the COVID-19 outbreaks in the country and the pandemic shut factories globally, businesses turned to China to make their goods. This year, as other manufacturing powerhouses like Vietnam faced fresh waves of COVID-19, China was again relied upon to fulfill backlog orders.

In 2018, due to the U.S.-China trade tensions, talks of ‘China plus one’ or shifting production out of China altogether were rampant. Yet, China’s exports continued to rise and even hit fresh records in recent months, like it or not, thanks to strong U.S. and EU demand. Meanwhile, the U.S. trade deficit widened to a record in August as American consumers continued to binge on imported goods. Specifically, the U.S. trade deficit with China expanded to $31.7 billion in August – the widest gap since July 2019.

Source: Bloomberg

The Biden administration has continued the tough public façade of confronting China on trade. Katherine Tai, the U.S. Trade Representative, provided no hints that she intended to lift the tariffs implemented by the last administration. Furthermore, Tai expressed a plan to shift the efforts from securing market access and instead focus on pursuing “smarter, more resilient trade” with a more holistic policy. This led to words of caution from Anna Ashton, vice president of government affairs at the U.S.-China Business Council, who disclosed “most of our companies say they can’t be successful globally if they are not successful in China.”

Source: Barron’s

The Biden administration’s approach on trade negotiations with China appears to run antagonistically with American firms. For instance, the American Apparel & Footwear Association [AAFA] on September 27 called for the extension of tariff exemptions for products such as medical care ones to supply hospitals and health care workers.

The AAFA is requesting the White House to do more, arguing that across-the-board tariff relief would “help manufacturers, farmers, and retailers offset extraordinary freight costs this year” amid an upheaval in the shipping industry ravaged by the coronavirus pandemic. While the tariffs are good for optics – giving the impression that China is suffering from the imposition – it is the business community in the U.S. that is being punished.

“At a time when industry is struggling with an unprecedented supply chain crisis due to our crumbling infrastructure, economic fallout from a damaging pandemic, and unprecedented freight costs, it is distressing that the administration has chosen to continue to subject U.S. companies to these damaging taxes. Although restarting an exclusion process is an important step forward, the far better course would have been to discontinue use of these tariffs entirely.” – AAFA President Steve Lamar

Chinese equities have been hammered since the trade tensions escalated in the second half of 2018. If Tai accedes to the demands of the American businesses and removes the tariffs, it wouldn’t be U.S. firms celebrating. Shareholders of Chinese stocks would cheer too, as the move would likely boost sentiment and see investors returning.

Perhaps market players have already positioned themselves ahead of such a possibility. The Chinese Internet sector representative ETF, the KraneShares CSI China Internet ETF (KWEB), zoomed past the broader Chinese ETFs, closing up 9.4 percent for the week. Among the key holdings of the KWEB ETF, the share price of Full Truck Alliance topped the leader board of gains with a 15.3 percent jump.

However, this came on the back of its 11.3 percent decline the previous week. YMM stock remains volatile in the absence of updates from the regulatory investigation that began soon after its IPO in June. At Friday’s closing price of $16.45 per ADR, the stock is a double-bagger for those brave enough to scoop some shares when it traded in the sub-$8 level in late July.

In August, Citi initiated coverage of Full Truck Alliance with a Buy rating and assigned a price target of $19.50. The analyst was optimistic that the logistic-technology company could further entrench its leading position in the large full-truck-loaded market and widen its penetration into the less-than-loaded and intra-city transportation markets.

Meanwhile, investment professionals are getting less shy in admitting their re-entry into China stocks. Seeking Alpha’s Breaking News service keeps investors updated on such developments. The following snapshot from Thursday’s alert is an example.

Source: Seeking Alpha

I was also informed of an 82 percent increase in Charlie Munger’s Daily Journal Corporation investment in Alibaba Group via Seeking Alpha Breaking News. This is short of a doubling-down in its ownership in Alibaba but it must have been one of the drivers of BABA stock last week.

It was, again, through SA’s Breaking News that I became aware of Alibaba topping WallStreetBets mentions last week. While it’s debatable whether this was a bullish driver or a consequence of its rebound, it doesn’t seem to be a bad thing to be hot-trending on Reddit’s popular WSB channel.

September gaming data powered NetEase’s strong weekly gains

Hot on YMM’s heels was NetEase which climbed 14.9 percent. NTES stock was previously bogged down by the abrupt regulatory shift in the after-school tutoring industry which affected its edtech unit Youdao, a tighter restriction on gameplay time for children, and conflicting reports of a freeze in videogame approvals in China.

The drag from the latter cause was inexplicable as William Ding, the CEO of NetEase, had dismissed the veracity of a ban. Furthermore, South China Morning Post, the Hong Kong-based media outlet owned by Alibaba Group which first broke the news, later softened the story to suggest there would be a slowdown in approvals, rather than a total suspension.

Regarding the potential adverse impact from reduced children’s gameplay, Charles Yang, Chief Financial Officer of NetEase, clarified during the second-quarter earnings call that under-18s accounted for less than 1 percent of NetEase’s total games gross billing. Thus, I argued in an earlier article that “even if the Chinese government had barred the children from playing altogether, the steep slumps in the share prices on the news wouldn’t have commensurated with the financial fallout.”

Besides, Chinese kids have already found workarounds to increase their game time. During the weeklong holiday in China last week, Chinese social media were rife with postings describing children using an adult’s account to bypass the restrictions. Parents who wanted some long-awaited rest time for themselves were more than happy to oblige. Until the regulators demand constant verification via facial recognition for uninterrupted gameplay, it seems young gamers would have their way.

For better or worse, investors have become more skeptical of reassurances from the executives of Chinese internet stocks. Hence, the favorable data from the independent insights company Sensor Tower last week provided a strong dose of confidence for quelling the doubts shareholders had regarding the performance of its games.

According to Sensor Tower Store Intelligence preliminary data, NetEase’s mobile game Harry Potter: Magic Awakening was ranked first on China’s iPhone mobile game download list for more than 20 consecutive days since it was launched in early September. It was also among the top three best-selling iOS mobile games in China. Propped up by the game, NetEase’s mobile game revenue in September jumped 38 percent month-on-month and 26.2 percent year-on-year.

NetEase is not a one-trick pony. A local securities report noted that a series of popular games from NetEase was a testament to its internal research and development capabilities. Furthermore, the company has several upcoming games in the pipeline aimed at the global audience and leveraging well-known global blockbusters including Diablo: Immortality and Lord of the Rings: Rise to War.

Tencent’s release of its mobile game League of Legends: Wild Rift in China on Friday should serve as a solid rebuttal to naysayers still insisting there was a ban on game approvals. While the game’s launch in China has taken longer than anticipated since receiving a license back in February, its eventual release amid the intense scrutiny from Beijing over concerns on gaming addiction proved Tencent is capable of adapting to more stringent regulatory requirements. Shareholders of NetEase probably felt the release boded well for the company as well.

There was also a positive development on Youdao recently. I shared in the penultimate CIW that the online education and digital tools provider announced it was selling its Academic AST Business to an unnamed buyer in order to comply with China’s revamped regulatory requirements on after-school tutoring.

Meituan’s antitrust conclusion is a positive signal for Alibaba

E-commerce players did well too. Shares of JD.com, Alibaba Group, and Pinduoduo rose 12.5 percent, 12.4 percent, and 9.1 percent respectively. The dismal performance of Trip.com among the top holdings of the KWEB ETF is making it stick out like a sore thumb. However, this is coming after it led the gainers the prior week.

The conclusion of the antitrust investigation into Meituan culminating in a 3.44 billion yuan (US$533 million) fine on Friday could potentially be a positive for Alibaba Group. The fine amounted to around 3 percent of Meituan’s total domestic revenue of 114.7 billion yuan in 2020. The regulators also instructed Meituan to refund the exclusive cooperation deposits it collected from the merchants which totaled 1.29 billion yuan.

I expressed previously that it was a blessing in disguise that Alibaba was the first to be investigated as its fine would be based on its revenue in 2019. Given the high growth these internet platforms deliver, the earlier the conclusion, the smaller the revenue on which the fine would be based on. In this respect, I can imagine the bulls saying light-heartedly that the authorities were playing favoritism and prioritizing Alibaba in their crackdown on monopolistic practices.

On a more serious note, it’s worth recalling back in August that The Wall Street Journal reported China’s antitrust regulator was preparing “to impose a roughly $1 billion fine” on Meituan, “according to people familiar with the matter.” Many other media outlets including Bloomberg went on to cite the WSJ scoop.

Source: Bloomberg

With the eventual fine just around half of the purported figure, investors should use this episode as a lesson that even reputable publications can get it wrong. Furthermore, unverified information propagated by more media outlets doesn’t make it a fact.

Given that the stock jumped on the much lower than leaked figure, it reflected somewhat the monetary loss suffered by those who were taken in by the fear perpetuated by unofficial sources. To be fair, part of the jump in Meituan’s share price should be attributed to the bullish Golden Week spending data mentioned in the earlier section.

The company announcement on the antitrust conclusion stated that Meituan had voluntarily admitted to, and suspended the practice of “pick-one-from-two” conduct as well as implemented “comprehensive self-investigation and rectification” which supposedly played a part in the authorities meting out lower penalties. Indirectly, it’s a message to the world that Alibaba was not alone in monopolistic practices and that it wasn’t singled out by the Chinese government.

Tellingly, the market regulator ordered Meituan “to rectify its competing acts in all aspects, protect the lawful rights and interests of all participants on the platform, enhance its internal controls and compliance, and uphold a positive competitive ecosystem of the platform.” Compliance would put Meituan on the same footing as Alibaba Group. Thus, no one can suggest the latter will now be alone in being “hobbled” by the tougher regulations, especially Alibaba’s Ele.me on-demand local services platform which is in direct competition with Meituan’s bread-and-butter business.

As explained in a past issue of the Chinese Internet Weekly, I found the KWEB ETF holding the most representative stocks in the sector. As such, an overview of the week’s share price movements of the top ten holdings of KWEB (as of Friday) compared with the ETF itself is provided as follows for convenient reference especially for the stocks mentioned in this article.