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Introduction
With the S&P 500 making new record highs, the concern that broad-based stock valuations are getting overstretched is warranted. Hence, we have been scouring the market for areas with relatively better value.
One sector that has piqued our interest is China Tech, especially given the significant sell-off in the past two months. Mega-caps such as Alibaba and Tencent are trading 20% below their recent peaks, while higher growth companies such as Nio and BYD are 40% below recent peaks.
In this article, we give our views on whether the sector is worth investing in at current valuations and what’s the downside risk from here.
For investors keen to invest in China Tech stocks, our follow-up article reveals which ETFs are optimal for investing into the sector, and the China Tech stocks with the highest implied upside to analyst consensus target prices.
Article Summary
1) Historical Performance of China Tech Stocks
2) Why China Tech stocks are down 27% since Feb-2021
3) Are China Tech stocks expensive?
The InvestQuest View:
As long-term investors, we do see a thesis for building up exposure to China Tech stocks. While fundamental risks to the sector remain elevated, we believe they have already been priced into current valuations and we would be gradually accumulating from here. At the margin, we see some of the key risks receding, and this may catalyze stock price consolidation for the sector.
In Part 2 of this article series, we reveal which ETFs are optimal for investing into this sector, and which China Tech stocks have the highest implied upside to analyst target prices.
1) Historical Performance of China Tech Stocks
When you hear of China Tech, the companies that immediately come to mind are Alibaba and Tencent. Yes, they are the largest companies within the sector but there’s much more to China Tech than these two companies.
In our view, China Tech Stocks can broadly be categorized in two ways:
- Underlying business model: Software vs Hardware
- Listing venue: ADRs vs A-Shares vs H-Shares
And depending on your desired exposure, you will need to know which China Tech index to track. We won’t go into details on this for now, and will revisit this in the subsequent article.
The below chart shows the historical performance of China Tech stocks, which has declined 27% since mid-Feb. We used the MSCI China Tech 100 Index as a gauge, which includes Chinese Software and Hardware companies, which are traded on either China onshore or offshore exchanges.
2) Why China Tech stocks are down 27% since Feb-2021
We see four reasons that contributed to this and will explain on each of them briefly:
- Concerns over rising US Treasury yields
- Worries of China ADR delistings
- China government’s clampdown on big tech
- Spillover impact from Archegos blow-up
1) Concerns over rising US Treasury yields
The 10-year US Treasury yield has risen from 0.9% at the start of 2021 to 1.7% currently.
Elevated rates volatility would have a relatively larger negative impact on high growth stocks (which includes China Tech), as a relatively large proportion of their value is expected to be realized only in 5 to 10 years time, and higher rates could result in a higher return threshold (or discount rate) demanded by investors.
In the chart below, we plotted the 10-year US Treasury yields since 2001, compiling the dates where there had been a short-term spike in UST yields (circled in red).
While we do believe that rates would trend upwards over the next few years, we think that the magnitude of the recent yield spike has been in line with the largest historical short-term rate spikes and further increases would likely be more controlled from here.
In short, we think that this risk is fading, which could be incrementally positive for China Tech stocks.
2) Worries of China ADR delistings
In March 2021, the SEC adopted a law called the Holding Foreign Companies Accountable Act. This law would result in a delisting of foreign companies from US stock exchanges, if these companies fail to comply with US regulatory audits for three consecutive years.
As Chinese regulators forbid the sharing of such audit data as per Chinese law, Chinese ADRs are left in a bind and will most likely just fail the audit.
Personally, we are less concerned about this risk at the moment because of two reasons:
- There’s almost another three years to go before any actual delisting is required.
- Some of the larger Chinese ADRs (Alibaba, Baidu, NetEase, JD.com) have already executed secondary listings on the HK Stock Exchange.
3) China government’s clampdown on big tech
Similar as in the US, China’s big tech firms have also gotten increased scrutiny, given their wide-reaching social impact.
- For example, Alibaba saw its affiliate Ant Financial’s IPO being shelved, was separately fined US$2.8bn for anti-monopolistic practices and may soon have to divest its media assets (which includes South China Morning Post).
- Just today (13 Apr 2021), China ordered 34 internet corporations to rectify their anti-competitive practices within the next month.
- Separately, the increased scrutiny has also resulted in a record number of companies abandoning their planned IPOs on the Shanghai Star market (China’s equivalent of the Nasdaq). In March 2021 alone, 76 companies suspended their IPO applications!
On a more optimistic note, majority of research analysts view the conclusion of Alibaba’s anti-monopoly investigations positively as it removes the regulatory overhang while avoiding the worst-case scenario (a break-up of Alibaba).
In our view, this is the biggest risk factor for China Tech stocks at the moment.
4) Spillover impact from Archegos blow-up
There was a family office that blew up recently, due to a case of overleverage. As a result, the firm had to liquidate its portfolio holdings, which included significant exposures to Chinese tech stocks Baidu, Tencent Music, Vipshop and iQIYI.
Some investors were concerned that the steep price decline of these stocks would trigger a domino effect of margin calls across other overleveraged investors.
Fortunately, the damage seems to be contained, and might have created an opportunity for investors to purchase oversold stocks whose fundamentals have not changed.
At the margin, we do see the above-mentioned risks receding gradually, and are hopeful that this will catalyze price consolidation for stocks within the sector.
3) Are China Tech stocks expensive?
In the previous section, we looked at the fundamental risks facing the Chinese Tech sector. One thing we had not mentioned yet is valuations.
As long-term investors, we believe that China Tech stocks are inexpensive currently. We arrived at this conclusion by consolidating financial data from a basket of selected China Tech stocks. Our stock basket features the largest Chinese software and hardware tech companies, which had been listed in 2015 or earlier, on either onshore/offshore stock exchanges. This includes:
- Tencent
- Alibaba
- Baidu
- JD.com
- NetEase
- Trip.com
- Luxshare Precision
- BOE Technology Group
- Sunny Optical
- ZTE Corp
- SMIC
- Kingdee International Software
- JOYY Inc
Market Cap (+25% p.a. since Dec-2015)
The combined market cap of this stock basket has grown by 25% p.a. since Dec 2015! It was ¥3.8 trillion in Dec 2015, compared to ¥12 trillion currently (and that’s after a significant sell-off).
Before you conclude that China Tech is in bubble territory, we do have to check if revenues and net profits of this stock basket have managed to grow at a similar pace.
Revenues (+29% p.a. since 2015)
The chart below shows the combined revenues of all stocks within the basket by calendar year. We note that since 2015, combined revenue growth has been 29% p.a. (faster than the growth in combined market cap).
Revenue growth of this stock basket is not expected to slow down in 2021/2022, as we see relatively optimistic projections from consensus analyst projections (highlighted in beige in the chart below).
Net Profit (+35% p.a. since 2015)
The chart below shows the combined net profit of all stocks within the basket by calendar year, which grew at +35% p.a. since 2015.
2020 has been a bumper year for tech-related companies, and we did see a significant profit boost to the sector. According to analyst consensus projections, profits are expected to normalize in 2021, before continuing a strong ascent in 2022/2023.
Now on to valuation metrics…
Using this above data, we computed valuation ratios such as Price-to-Sales, and Price-to-Earnings of this stock basket across time, to better judge if current valuations are cheap or expensive vs history. We also looked at the implied valuation multiples based on 2021-2023 analyst consensus financial projections.
Valuation Metric: Price-to-Sales ratio looks fair
We compute the stock basket’s Price-to-Sales ratio, by dividing the “combined market cap” by “combined revenues” shown earlier.
At 5.1x currently, it’s in line with the historical 5-year average of 5.2x. Analyst consensus for 2021/2022/2023 revenues imply 4.0x/3.3x/2.9x forward multiples respectively.
What’s our best estimate of the downside risk for this stock basket? If we assume that the current sector sell-off takes us to the trough multiple of the past 5 years at 4.2x, this implies a further downside of 18% for the stock basket in a bear-case scenario.
Valuation Metric: Price-to-Earnings looks relatively cheap
We compute the stock basket’s Price-to-Earnings ratio, by dividing the “combined market cap” by “combined net profits” shown earlier.
At 28x currently, it’s meaningfully cheaper than the historical 5-year average of 37x. Analyst consensus for 2021/2022/2023 implies 30x/26x /21x forward earnings respectively, which is inexpensive in our view.
The InvestQuest View:
As long-term investors, we do see a thesis for building up exposure to China Tech stocks. While fundamental risks to the sector remain elevated, we believe they have already been priced into current valuations and we would be gradually accumulating from here. At the margin, we see some of the key risks receding, and this may catalyze stock price consolidation for the sector.
In Part 2 of this article series, we reveal which ETFs are optimal for investing into this sector, and which China Tech stocks have the highest implied upside to analyst target prices.
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