Alibaba: A Lesson In Investor Psychology

Summary

  • Companies achieve high valuations at the capricious, manic-depressive pleasure of the markets.
  • Alibaba’s FY2022Q3 results weren’t that bad, though guidance is down more sharply. This looks to be mainly a function of a macroeconomic slowdown, intense competition, and difficult 2020 pandemic comps.
  • Property sector fallout is a wildcard that could worsen the macroeconomic slowdown and add further to already-negative sentiment.
  • But the valuation has dropped enough that delisting should present less downside. With the regulatory front calming down, the risk-return trade-off looks better than previously in 2021.
  • The past 6 months have been a lesson in investor psychology. In the short term, how others perceive the situation is just as important as the facts themselves.

Investment Thesis

Alibaba has been caught in a perfect storm of poorly-understood Chinese regulatory actions, risk of delisting by U.S. regulators, a macroeconomic growth slowdown, a brewing property sector crisis, difficult pandemic comps, and intense competition. The relentless sell-off is also a stark lesson in investor psychology – you can try to be “smart” and reason through the facts in a balanced way, but in the short term, the market is a voting machine. Even if you’re right, others will perceive the facts in their own way, and the market price will be determined accordingly. Many investors might not discern one risk factor from another – instead, they just see a stock price that keeps going down, so they conclude that the situation is increasingly more bleak.

And yet, an evisceration of Chinese internet tech companies at the hands of the CCP, as predicted by some, doesn’t look to be in the cards – though anti-monopoly efforts could have aided the intensifying competition. FY2022Q2 revenue and earnings were 2% and ~10% below expectations – increased investment in high-growth categories, which are still unprofitable, helps to explain the latter. Worries about delisting also look less warranted at this price level – for example, Chinese telecoms with revenue growth typically around ~3% that have already been delisted trade for ~7x P/E. Alibaba trades for a FY2023 forward P/E of ~11.5x as of Wednesday’s close, and accounting for its negative leverage, this is more like ~9.7x. Overall, I’d view the risk-return trade-off as better than at any previous point in 2021.

Reflecting On The Past 6+ Months of BABA’s Downward Spiral

Although I have been relatively equivocal and cautionary about risks to investing in BABA and Chinese equities, in previous articles, and leery of the short-term downside risks, ultimately, I opted to remain optimistic. A key shortcoming of my bullish conclusions, I believe, was to not fully admit the role of investor psychology, and how others might perceive the same events. Many investors are not going to try too hard to put things in perspective – this does take effort, after all – and will settle for easier narratives.

To compound this fact, new developments can change the risk-return profile, abruptly – one has to be ready to change one’s mind on a dime, or at least adjust exposure accordingly, when the evidence suggests it’s warranted. Case in point, while there are explanations, of sorts, for the education sector crackdown or DiDi’s listing/delisting debacle, the optics were not great – these events added to a climate of confusion/anxiety that already existed. VIEs, and subsequent developments, which might have otherwise been brushed off by the market, have instead been seen in a negative light.

One common narrative is that the CCP wants to hamstring major Chinese tech companies to prevent them from growing too large/powerful. Anti-monopoly measures and other regulations do present new challenges relative to a “cowboy business culture” which may have prevailed in previous years. But if Beijing/the CCP/regulators were planning on dismantling Alibaba, they had better get to work – the stock price is now barely above 2015 levels, but revenues are still up more than 1000%, and EBITDA, cash from operations, and net income are up roughly 4x or more. Overall, though, the regulatory front has seemed to quiet down throughout 2021H2, even as the stock price has continued to erode.

Data by YCharts

Two company-specific risks for Alibaba that I highlighted as warranting relatively more concern included (1) delisting by U.S. regulators, and (2) domestic competition. Recent developments have continued to validate these concerns. But some aspects of China’s country risk have only come into sharper focus since then, e.g. most recently Evergrande, the property sector’s weakness, and the macro slowdown. Some might think this is the CCP’s doing, as well! Robust growth would normally have been a saving grace for BABA.

The following table recaps events that have startled investors over 2020-2021. Some events should look relatively minor, or not directly impactful for BABA, as they recede into the rearview mirror. In other cases, like with the derailing of the Ant Group IPO, the valuation impact is clearly significant – Ant Group’s valuation was once expected to reach $280B, but some estimates have since been slashed to below $100B. So it’s a mixed bag – I’ve subjectively rated the entries, based on the impact on Alibaba’s fundamentals.

Event Date Description Impact on fundamentals
Ant Group’s IPO hiatus Nov-2020 Ant was asked to restructure as a financial holding company. There have been rumours of a restart, but more recent speculation is that it won’t happen before 2023. High
Jack Ma’s disappearance Nov-2020 Reappeared, multiple times, though keeping a low profile. None, but symbolic importance.
Anti-monopoly fine of $2.8B Apr-2021 Not a large fine. Low
Anti-monopoly regulation of platform economies 2021 Medium-term headwind (reduces monopoly power), though could have longer-term benefits for the economy. Medium
DiDi’s listing and delisting debacle Jul-2021 DiDi may have defied regulators and pursued U.S. IPO, anyways. None
Education sector crackdown Jul-2021 Disconcerting, but relates to demographic crisis. Very likely to be mostly-isolated and sector-specific. Low
China cracks down on overseas listings Jul-2021 Chinese regulators have since proposed stricter rules for overseas listings, not a ban. None
$15.5B of common prosperity investments, over 5 years. Sep-2021 Probably overlaps, in part, with investments that would have been made, anyways. Unclear, maybe medium.
Evergrande debacle Sep-2021 Real estate is ~29% of China’s GDP, so a property sector slowdown is likely to be major macro headwind. Potentially high.
Delisting fears 2021 HFCAA was signed into law in December 2020 – not much new, since then. Chinese regulators are reportedly keen to find a compromise. None, but a valuation impact.
Other miscellaneous regulatory actions 2021 My favourite is still the “crackdown on pop-up ads”. Low

VIEs are a recurring concern for some – at BABA’s current stock price level, though, China hardly needs to expropriate anyone, because international investors have been doing it to themselves. Why bother with the hassle and blowback of expropriating something when your counterparty is willingly giving it back for a third of the fundamental value that many would have ordinarily ascribed? Instead, recent draft rules are supportive of overseas listings, as the “opening-up of China’s capital markets continues to deepen”:

[China Securities Regulatory Commission] Overseas listings have played a positive role in supporting Chinese companies to utilize foreign capital, enhance corporate governance, and deeply integrate into the global economy.

[…] As the opening-up of China’s capital markets continues to deepen, the initiative to improve the regulatory system for overseas listings has been proposed with the purpose of promoting the sound, sustainable and long-term development of Chinese companies listed overseas.

[…] The CSRC and relevant government authorities in China fully respect companies’ own choices for listing venues, and such attitude is consistent, clear, and unswerving.

[…] existent overseas listed companies will be allowed sufficient transition period to complete their filing procedures.

[…] If complying with domestic laws and regulations, companies with VIE structure are eligible to list overseas after filing with the CSRC.

Source: China Securities Regulatory Commission (CSRC).

This doesn’t make it sound like VIEs are in jeopardy anytime soon. Furthermore, a motivation for greater oversight of overseas listings is reportedly to prevent fraud – unsurprisingly, Chinese regulators have found that accounting frauds have “damaged the international reputation of Chinese companies”.

Evergrande and the weakening property sector do not directly impact Alibaba, but are likely contributing to the macroeconomic slowdown, along with weaker consumption growth. The embattled developer’s demise seems inevitable, even as it has limped along for months. There’s some mention that regulators are taking measures to ease a hard landing. Media reporting on the topic is fairly superficial, and it’s hard to gauge the severity of macro tail risks, in general. Any uncontained fallout could prompt a deeper rout of Chinese equities, dragging BABA further down – though it’s now looking like a lot of risk is priced-in.

FY2022Q2 Results: Slower But Gets The Job Done

Alibaba is hardly unique in having seen a slowdown in growth, versus other e-commerce companies and beneficiaries of pandemic lockdowns. But anything short of a beat was unlikely to assuage doubters, given the mood around BABA. The following table compares Alibaba with Amazon according to some key operating metrics. Their decelerations are similar, but the latter is down about ~10% from all-time highs, while Alibaba is down 31% just since FY2022Q2 results, and almost ~65% from its all-time high.

Sources: Company earnings slides – FY2021Q3 and FY2022Q2 for Alibaba, 2020Q4 and 2021Q3 for Amazon.

Some highlights from FY2022Q2:

  • Softer market conditions in the past six months with slowing consumption growth in China, and 20-23% y/y growth expected for FY2022, implying a noticeable slowdown, in the next six months. This is down from 29.5% y/y growth that was previously expected.
  • Global annual active consumers reached ~1.24B, +62M q/q, and +20% growth y/y.
  • Robust revenue growth with international e-commerce (+34%) and cloud (+33%), which are in their early stages, and account for 17% of total revenue. E.g., Lazada in SE Asia had order growth of 82%, and Trendyol in Turkey had GMV growth of +80%.
  • Alibaba delivered a new server chip, server architecture, AI, big data, and database solutions.
  • Gross margins decreased “due to higher proportion of our direct sales business, mainly from the consolidation of Sun Art”.
  • The decline in Adjusted EBITA was largely accounted for by “investment in strategic areas and merchant support”.

Source: Alibaba Investor Day 2021 – Financial and Investment Perspectives.

Source: Alibaba FY2022Q2 results. Cloud segment.

As domestic e-commerce competition intensifies with new entrants, management has pointed to its “multi-growth” engine and increasingly diversified business. Avenues for growth include international, cloud, loyalty programs, local consumer services, logistics, etc. while it aims to maintain leadership in domestic e-commerce. China’s cloud market size, for example, is expected to grow almost 5x by 2025, from 2020’s level. Local consumer services are estimated to grow to a TAM of RMB35Tn by 2025 (~$5.6Tn), from RMB20Tn in 2020, with a lot of room for more penetration – this category includes Ele.me and Amap.

Source: Alibaba Investor Day 2021 – Alibaba Group Strategy.

Source: Alibaba Investor Day 2021 – Alibaba Group Strategy.

Alibaba’s Potential Delisting Looks Like Less of an Issue at This Stock Price Level

I’ve previously argued that delisting is a risk that shouldn’t be brushed aside. Although many investors could exchange their shares for HKSE-listed ones, if BABA is only listed on the HKSE, it wouldn’t get the kind of multiples lavished on U.S. tech – but lately, it hasn’t been getting those multiples, anyway. The multiples are getting so depressed that it’s not even clear whether a delisting would have a much lasting effect on valuation, in the medium term.

One can look at valuations of stocks that are listed solely on the HKSE, for clues as to how Alibaba’s valuation might be impacted by delisting. For example, Chinese telecoms that have already been delisted trade at roughly ~7x P/E multiples. Alibaba is at 12.0x (TTM) and 13.5x (FWD), but its growth rate for the next five years is still likely to be greater than that of a telecom – taking out its net cash, equivalents, and short-term investments of ~$50B, its P/E multiple would be closer to ~10.1x (TTM) and ~11.3x (FWD).

Exchange Revenue, CAGR (2016-2020) Revenue CAGR (FWD), until FY2023 EPS (TTM) P/E (TTM)
China Mobile HKSE 2.0% 5.44 RMB 7.1x
China Telecom HKSE 2.8% 0.31 RMB 6.8x
China Unicom HKSE 2.6% 0.461 RMB 6.9x
Alibaba NYSE ~38%* 11%-19% (low to mid est.) $9.33 12.0x

Source: Company financial reports, Seeking Alpha, author calculations. *Excludes Sun Art acquisition, uses FY2022Q2 TTM revenue.

DiDi Global Inc. is down 60%+ from its June 2021 IPO price of $14 – confirmation of its delisting itself sent the stock price down from the $8 range to a sub-$6 level. We should note that DiDi’s delisting risk looked fairly serious almost right from the start, as DiDi may have flaunted the concerns of Chinese regulators and proceeded with its U.S. IPO, anyways.

The factors behind Alibaba’s own delisting concerns, though, are entirely different and are instead instigated by U.S. politicians, i.e. with the Holding Foreign Companies Accountable Act (HFCAA). While a delisting would be a couple of years away, investors strive to be forward-looking. The delisting risk pits China’s unyielding “national security” concerns against a U.S. Senate/Congress that could aim to score easy political points, or use U.S. market access as foreign policy leverage.

Chinese regulators sound keen to find a compromise, although the PCAOB’s expectation of being able to access audit documents of U.S.-listed firms seems pretty straightforward. It doesn’t look like U.S. legislators/regulators want a compromise – time will tell what can be worked out.

A Lesson in Investor Psychology

As stated already, part of my own over-optimism has resulted from an underappreciation of the investor psychology around BABA’s short-term stock prospects. Short-term investing is more akin to Keynes’ beauty contest, where investors guess “what average opinion expects the average opinion to be”. Richard Thaler, the 2017 Nobel Memorial Prize-winning economist, likens the issue to the following puzzle/contest with multiple players, in his book “Misbehaving”:

Guess a number from 0 to 100 with the goal of making your guess as close to two-thirds of the average guess of all those participating in the contest.

If players guess randomly, then the average guess would be 50 and the winning guess would be ~33 (on average). Many would anticipate this, though, and guess a lower number, e.g. 22, and so forth. The correct answer, assuming that all participants are perfectly rational and follow this logic to its conclusion, is [spoiler alert] zero. As it turns out, though, all participants are not rational. In one experiment with readers of the Financial Times, the winning guess turned out to be “12”.

Right now, investors are trying to figure out whether to buy/sell Alibaba, in an effort that shares some characteristics with this puzzle, though a good stock price prediction is bound to be harder. Thrown into the mix for BABA are fears about delisting, regulatory crackdowns, slowing growth, and other people’s fear – all in terms of “average opinion”, and with respect to an emerging market that probably many don’t understand that well. If anything, some talking-head experts seem to add to the fear/confusion. It becomes that much easier to misinterpret, so the extreme volatility of emerging markets is perhaps to be expected. The market isn’t going to give Alibaba the same benefit of the doubt as, say, Amazon, despite the similarity in growth slowdown.

Professional asset managers who invest in Chinese equities could similarly have to contend with anxious investors who have seen sensational headlines about China’s regulatory crackdowns. In contrast, the career risk of investing in blue-chip American companies is probably relatively minimal, even if there was a drawdown.

Reasons for Optimism in 2022

With investor psychology/sentiment being a key factor that has beaten down BABA in 2021, one could legitimately wonder why this trend should ever abate. Some reasons to be optimistic for 2022:

  • BABA’s valuation is now rather depressed, placing it in nearly the same category as low-growth Chinese telecoms that have already been delisted. A lot of risk looks priced-in.
  • There’s been a slow-down in major regulatory action, and the CCP is apparently on board with seeing Alibaba recover. The market should realize, in time, that the narrative of the CCP trying to suppress major internet tech companies does not stand up to scrutiny.
  • Although hard to gauge its magnitude, any tax-loss selling should reverse.
  • Momentum trading will reinforce whichever way sentiment and fundamentals take things, so this could potentially turn into a net positive.
  • Chinese equities are not the only stocks to have seen carnage in 2021H2. Despite the market still being near all-time highs, many sectors and stocks are well-below their own 52-week highs, for various reasons.

The last point can be helpful to acknowledge, as there’s a tendency for price to influence investors’ views of a company’s prospects, rather than just the other way around. This becomes especially relevant when a stock is already predisposed to FUD. Chinese equities have seen a bigger sell-off than most categories, but at least part of this could be attributed to a generalized pullback on riskier stocks facing headwinds, in favour of U.S. mega-caps like Apple that have particularly benefitted in 2021.

Reasons for Caution

While the risk-return trade-off for BABA has improved, risks still remain. Many of these should be familiar, by now:

  • A weakening property sector would exacerbate any economic slowdown. Weaker consumption growth could be misconstrued with other perceived risks that Alibaba is facing.
  • Delisting risk looks priced-in, in terms of potential downside, however, overhang from this issue could limit upside as long as no resolution materializes.
  • Intense competition and anti-monopoly measures could likely result in some lasting reduction in core e-commerce margins. Any underperformance relative to expectations would likely weigh on the stock price.
  • Segments with robust growth are not yet large enough to offset any significant weakness in core e-commerce.
  • China isn’t finished with regulating its economy – market perception will partly come down to how this is communicated.
  • A lot of e-commerce companies, in general, are probably looking at a slower-growth future, after the pandemic pulled adoption forward.
  • It could take quite a while (e.g., several quarters) for sentiment to recover, even to a mid-2021 level.

Diversification is one obvious counter-measure – for any particular emerging market, my aim is to keep total exposure to a single-digit percent.

Summing Up

Chinese equities had deserved some punishment in 2021. Chinese regulators may have had a rationale for their policy actions, but didn’t do themselves any favours with abrupt actions and poor communication. Media interpretations haven’t always helped, and markets have, in turn, reacted in their typical manic-depressive way. Maybe this is how it should be – it could help, in some small way over the long-term, to encourage foreign/corporate powers to be more mindful of keeping the markets placated. China wants continued access to capital, and for that, it helps to not rock the boat, too much.

Alibaba is indeed seeing slower growth. This is not unlike other e-commerce players, and pandemic beneficiaries, in general – though China is looking at a macroeconomic slowdown and property sector weakness, on top of this. But this has to be put in the context of valuation – BABA has fallen to a valuation level not much higher than already-delisted Chinese telecoms. Furthermore, growth prospects like international and cloud still have long runways. The Chinese regulatory stance towards overseas listings and VIEs has been clarified, somewhat. BABA could drop further – at this point, though, I think that BABA-bears looking for a much steeper decline are pushing their luck.

Let me know your thoughts and feedback on BABA, in the comments below.

Author: Northern Reflections on Value, Seeking Alpha

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