The Investment Case for Chinese Stocks
Triggers and chances for a reversal as well as upside potential
Summary
Chinese stocks have drastically underperformed global peers in recent years.
The bottom may finally be in as Chinese policymakers decisively address the problem.
I added to my China exposure on recent announcements at “dirt-cheap” valuations.
Depressing Sentiment Around Chinese Stocks
In my recent article I have outlined why I am excited about the potential of emerging market stocks. Now, Chinese stocks are even cheaper and they may have the better trigger to change that in the near term.
The chart below shows the cumulative index performance of the MSCI China. Effectively, Chinese stocks have been dead money since 2010, despite the fact that the MSCI China contains superstar companies like Tencent or Alibaba as the largest weights, vs. the CSI 300 that excludes these stocks.
A total return over 13 years is a depressing investment result and naturally many investors are throwing the towel, flocking into investment products with a better past performance. Interestingly, Chinese stocks have performed pretty well until 2021, but they have lost more than 50% of their value since then.
What happened in 2021?
In 2021, China introduced sweeping regulatory reforms in its stock market, significantly impacting both domestic and international markets. Termed as a pursuit of "common prosperity," these reforms aimed at curbing the unchecked power and influence of major tech and private education companies. They included stringent data security and antitrust regulations, especially for tech giants like Alibaba and Tencent, and a dramatic overhaul of the private education sector, essentially barring for-profit tutoring in core education subjects.
This unexpected regulatory crackdown was driven by broader socio-political objectives, including reducing wealth inequality, addressing concerns over data security, and exerting greater government control over large private entities. While the reforms were in line with China's long-term strategic goals, they caused considerable market volatility and uncertainty. International investors were particularly shocked, as these regulatory changes eroded market values rapidly and raised questions about the future of foreign investment in Chinese businesses. The move reflected China's shifting priorities, emphasizing social stability and control over the rapid growth and liberalization of its market economy.
The 2021 Chinese regulatory reforms, coupled with a slower-than-expected post-COVID economic recovery, had a significant impact on the fundamentals of the Chinese economy. The stringent regulations, especially in the tech and private education sectors, led to a decrease in investor confidence, both domestically and internationally. This resulted in diminished capital inflows and a notable drop in the stock prices of affected companies, thereby impacting the broader market sentiment.
Moreover, these regulatory measures, while aimed at long-term socio-economic stability, initially caused disruptions in business operations and planning, affecting the revenue and growth projections of several large companies. This coincided with the global economic slowdown and the challenges in recovering from the COVID-19 pandemic, such as supply chain disruptions and reduced consumer spending.
The combination of regulatory changes and a sluggish post-pandemic recovery led to a more cautious business environment in China. Companies faced increased compliance costs and uncertainties, potentially slowing down innovation and expansion activities. For the broader economy, this meant a slower pace of growth than anticipated, as the country navigated the challenges of balancing regulatory control with economic vitality in a post-pandemic landscape.
Is China Investible Again?
Apparently the collapse in Chinese stocks, along with a property sector crisis hasn’t gone unnoticed by Chinese Policymakers. 2023 has been a year that has been characterized by a number of measures aimed at supporting the stock market.
The figure below from Reuters illustrates the timeline for some of these measures. As evidenced by the performance of the CSI 300, they didnt’ help the stock market.
Is the Government Crackdown on Tech Companies Really Over?
In its totality, the measures outlined in the Reuters graph above appear to signal that Chinese policymakers have been changing their course and appear interested in limiting the damage that has been caused by the crackdowns that began in 2021.
In July 2023, Bloomberg titled that “China Ends Tech Crackdown With Fines on Tencent, Ant Group”. Indeed, Alibaba shares rallied that day on prospect of end to Beijing probe. For the following 6 months there were no noticeable government crackdowns and investors finally seemed to feel more confident about regulatory risks for Chinese stocks and a bottom in share priced appeared to have formed.
Until in December 2023, a sudden regulatory announcement in China proposed severe restrictions on online gaming, targeting companies like Tencent and affecting other tech giants such as Alibaba. This move caused a sharp decline in Chinese tech stocks as investors were shocked by an apparent revival of regulatory uncertainty.
However, in a swift reversal, the responsible regulator was dismissed on January 2, 2024. Moreover, on January 23rd, the draft video game rules were finally removed from a website. In my view, this withdrawal represents a strong indication that the government crackdown on Chinese tech companies is really over at this point.
What Speaks for a Reversal in Chinese Stocks
Momentum is a well-documented phenomenon in the financial markets. Or in other words: “Never catch a falling knife.” On the other hand, reversals do happen, ultimately breaking the momentum. Or to put it in another well-known saying: “The trend is your friend, until it breaks and then its the end.”
I have increased my China exposure to 20% of my portfolio as I sense a potentially violent reversal is on the horizon. In my view, the Chinese stock market combines dirt cheap valuations with a capital market environment that could not possibly get much worse at this point. On the other hand, a number of conflicting triggers are already in action or on the horizon.
Market Rescue Package
On January 23, 2024, Chinese authorities announced a substantial stock market rescue package designed to stabilize the slumping market. The package involved mobilizing approximately 2 trillion yuan (around $278.53 billion), primarily from offshore accounts of state-owned enterprises. This fund was intended to buy shares onshore through the Hong Kong exchange link. The package was part of a broader strategy announced by the cabinet, chaired by Premier Li Qiang, to inject mid- and long-term funds into the capital market to promote stability and healthy development. This rescue package can be seen as the most significant attempt yet to bolster investor confidence and stabilize the stock market, reflecting the Chinese government's commitment to supporting the stock market.
Global Investors are Dramatically Underweight Chinese Stocks
At this point the allocation of global mutual funds towards China is about the lowest ever since 2011. Between 2020 and 2023 global funds have reduced their China exposure from 15% to just 6.2%, sending shares lower in the process of exiting.
When the tide turns, they are at risk of underperforming their benchmarks and they may be relatively quick to increase their exposure.
Recovery of the Chinese Economy
China was about the last country to lift Covid restrictions. Only by the end of 2022, the country began to significantly opening up. Up to this point, the “bounce back” of the Chinese economy has not yet occurred. In fact, the confidence of the Chinese consumer is still at very low, though stabilized levels. Already in early 2023, economists warned that spending will be slow to jump back.
It appears to me that things in China are so bad, that the positive is that they can’t worse from here, but only better. The Chinese consumer is still busy hoarding cash and paying down debt. But on the positive side, this process is building up a lot of latent spending power.
If given a choice, would you invest in an economy where the consumer is totally stretched and indebted to the maximum, or one where debt is low, cash reserves are high? I believe the latter economy is in a much better position to surprise to the positive.
The former German economy minister Ludwig Erhard famously said “The economy is 50% (driven by) psychology.” I believe once sentiment in China improves, the recovery will have very long legs and we may well see the post-covid boom that many have been missing so far.
And if not even government measures help, then perhaps Chinese mythology? 2024 is the year of the dragon in the Chinese Zodiac. The Dragon is revered for its majestic aura and is synonymous with power, authority, and good luck. This symbolism is associated with bringing a sense of hope, adventure, and boundless possibilities, making the Lunar New Year of the Dragon a time of great anticipation and optimism.
“Historically, the Year of the Dragon has been associated with periods of economic growth. It’s often seen as an inflection point in economic development, particularly in China. The belief in the dragon’s auspicious nature tends to boost consumer and business confidence, potentially leading to increased spending and investment.” https://godofwealth.co/lunar-new-year-2024-year-of-the-dragon/
If enough Chinese believe it, I would not rule out that the economic dynamic in 12-18 months will be entirely different from today.
Firepower of the CCP and the Chinese Central Bank
Should the year of the dragon prove insufficient to trigger growth in China, it appears to me that there are at least two powerful significant levers that China has yet to pull:
a) Interest Rates
Chinese inflation runs currently at -0.3% a year. At this level of inflation, the US and Europe would long be back to zero interest rate policy (ZIRP) plus massive stimulative packages. Unbelievably to me, the China benchmark lending rate is at 3.5%(!) despite the deflation. China has just surprised the market with a 25bps cut, but I believe there are way more rate cuts to be expected. An appropriate interest rate policy for China will be extremely stimulative, incentivizing the Chinese to spend their cash and to take on loans.
b) Debt Capacity of the CCP
Chinese national debt to GDP currently runs at 77%, which compares to 123% for the US. The US is pushing its current GDP growth with an annual deficit of 9%. Given its low indebtedness, the CCP has substantial firepower to trigger economic growth via debt funding. However, I believe this is only a plan B. In my opinion, an appropriate interest policy should prove sufficiently stimulative.
Chinese Regulators Pushing for Stock Buybacks & Dividends.
China is actively pushing for share buybacks, which are of course extremely value accretive if shares are undervalued. In August 2023, the China Securities Regulatory Commission eased buyback rules to “support listed companies to launch share buybacks.”
In December 2023, China’s securities regulator went a step further, “asking publicly traded companies to boost dividends to reward investors and said it will increase supervision of those that don’t pay.”
In sum, I am sensing that China has switched to an extremely supportive regulatory environment for stock market investors. Global investors may need a bit longer to appreciate it, but 2023 and 2024 so far have brought tremendous change. China may soon be again a well-respected place for international shareholders.
The Property Bubble
The Chinese economy has been driven by construction and the housing markets have shown signs of a bubble that has at least partly bursted. While some equity of overlevered players may be wiped out and while some banks may have some losses on their loans, I believe China will ultimately move on to an economy that is less driven by property construction. It has to, also because of the demographic evolution.
While many investors well remember the global financial crisis and contagion across banks, I believe the situation in China is nowhere near comparable and the situation will remain under control. Spain had a construction boom fueled economy in the 2000s and they moved on, same for many other countries. I view the Chinese as very hard working, well educated, and the countries has developed leaders in numerous industries. Betting on China’s decline seems very misguided to me.
Another interesting aspect of China is that there is historically a strong cultural pressure to own real estate, while there is no stock market culture like in the US. The burst of the real estate bubble may change that view. The push of Chinese regulators may in fact help that the Chinese diversify their assets more towards stocks and less towards property or cash. After all, that would also be consistent with an economic model that moves away from construction as one of the main drivers.
One thing I can say with certainty: it is too early to call for a stock market bubble in China, as we are currently experiencing the exact opposite. But once the tide turns, I believe the Chinese stock market has a very long runway to grow into reasonable valuations. If we add a little excitement that could develop on that way, any recovery in Chinese stocks may well result in generational returns
Positioning
The majority of this write-up is dedicated to why I believe that now is the right time to load up on Chinese stocks. As outlined above, I believe that the chances for a reversal in the near term are high. If I am correct, then there are many ways to benefit from the recovery. ETFs on the MSCI China, or the CSI 300 come to mind.
As a stock picker, I prefer to invest in individual names that I believe have a good chance of outperforming the index benchmark. Below is a short overview of my four Chinese positions. This overview will focus on some of the valuation metrics that I track, indicating their cheapness, rather than a more qualitative writeup.
Alibaba (11%)
Market capitalization: $185.5b
Cash and short term investments on Sep 30, 2023: $85.6b
Consensus analyst expected EBITDA for FY 2025: $30.3B
Enterprise value: $124b
EV/2025 EBITDA: 4.1x
Dividend yield: 1.4%
Share repurchases 2023: $9.5b, reducing share count by 3.3%
The remaining amount of Board authorization for the share repurchase program, which is effective through March 2025, was US$11.7 billion as of December 31, 2023.
Based on these metrics, even without any future growth, Alibaba appears severely undervalued to me and would remain so even if the share price doubled. As a thought experiment, if Alibaba were to keep trading at the current valuation with the same buybacks, it would reduce the share count by one third over the next 10 years. Moreover, Alibaba would amass some $300b in EBITDA on top of its current cash holdings of $85 billion. The EBITDA yield on the current market cap would be 25%, while sitting on more than $300b in net cash.
Importantly, Alibaba has returned to significant growth in the most recent quarter. Q3 2023 revenue growth was 9% and the growth is a result of different business segment. Interestingly, it is exactly the cloud segment that is still weak, while it may offer among the largest opportunities in the long term.
Judging by the growth runway demonstrated by big tech in the US, large tech companies can grow for a long time. With Microsoft and Apple, the US now has two $3T companies. In China a few big tech companies are competing for the wallet of some 1.4b citizens that are becoming increasingly wealthy. Including the buybacks and the dividend yield, I believe that Alibaba stock has a shot at becoming a 10 bagger in the next 10 years.
JD.com (2.5%)
I posted on X about my new position in JD.com and the post has received quite some traction compared to my typical tweet (300 likes, 77k views in little more than a day). Here is what I wrote:
JD.com looking very good here:
5.5% free cash flow last 12 months
15% free cash flow yield on current market cap of $37b
Taking into account net cash, it gets crazy cheap:
cash and short term investments: $34.3b
short and long term debt ~$6.5b
—> net cash about $27.8b or 74% of market cap.
Interestingly, while JD currently pays a dividend yield of 2.6%, it has currently no buyback program in place. This is surprising given the push of the regulator for buybacks and the fact that JD could easily pull of a buyback program that would make Alibaba’s appear tiny. Moreover, any buybacks would be even more value accretive than for Alibaba given the more significant undervaluation. In my opinion chances are high that JD will announce a significant buyback program this year, which could by itself be a strong trigger for the share price.
If there is one negative about JD, then that revenue growth has recently fallen to 2% (vs. 9% growth at Alibaba). I anticipate that revenue growth at JD will reaccelerate once the Chinese economy improves.
Finvolution (5%)
FinVolution is a Chinese fintech company with a business model that focuses on empowering underserved markets. Its main offerings include the PPDAI platform, a popular peer-to-peer (P2P) lending platform, and products such as a small business gateway providing working capital and loans. The company also offers KOO Virtual Credit, a "buy now, pay later" service. FinVolution leverages AI-powered technology extensively across its platforms for various functions such as customer acquisition, loan matching, risk assessment, and collection services. This approach provides value to financial institutions while enhancing efficiency and accuracy. Finvolution is active in China and South East Asia:
Valuation Metrics
Finvolution currently has a market cap of $1.33b
By the end of Q3 2023, Finvolution had $781m in cash and $387m in short term investments
The PE ratio is 4.05 on a TTM basis and 3.7 based on expected earnings
Finvolution pays a 4.5% dividend yield
Finvolution has a $150m share buyback program in place
While Q3 revenue was up 7.6%, earnings were down 5.1%
Importantly, Finvolution already had a strong history of returning cash to shareholders even before the Chinese regulator mandated it. Since 2018, Finvolution returned $511m to shareholders.
JOYY ($YY) (2.5%)
Joyy Inc. operates a diverse array of social media platforms with a strong emphasis on video-based content, catering to a global audience. Their platforms include YY, Huya, and Bigo, which offer services like live streaming, interactive gaming, and social networking. The company's revenue streams are derived from virtual gifting, premium memberships, advertising, and partnerships. This business model leverages the increasing popularity of live streaming and real-time interaction globally, tapping into the growing market for online entertainment and community-building across different regions.
The most important business of YY is clearly BIGO, which ranks very high in the global app stores and appears on a successful track:
Bigo is also responsible for YY’s profits:
Valuation Metrics (excluding YY’s China Business)
YY currently has a market cap of $1.9b
By the end of Q3 2023, YY reported total cash of $3.8b(!)
Trailing 12 month Non-GAAP net income is $278.4b, representing a 15%(!) buyback yield.
The P/E ratio is 6.8 on a TTM basis
In the first 9m of 2023, YY bought back shares for $273.4b(!)
YY also pays a dividend yield of 5.5%
YY/Baidu Transaction
It is important to note that Baidu had agreed in 2020 to buy JOYY Inc's Chinese live video business YY Live for $3.6 billion. On January 1st 2024, Baidu said it was cancelling the planned purchase of livestreaming platform YY Live, partly blaming its inability to get government approval. YY is considering all options and seeking legal advice in response to the termination of the deal with Baidu. The failure of this deal would imply that JOYY now retains ownership of its China business, which includes the YY mobile app, YY.com website, and PC YY.
The transaction with Baidu was originally planned to be completed in 2021, so it did not come at a huge surprise that the deal is now (apparently) off the table. It will be interesting to see how YY deals with this new situation. In any case, the business appears severely undervalued to me. Any resolution to the topic might also be a trigger for the share price, allowing YY and its investors to finally move on.
Political Risks
Investors are increasingly concerned about the tensions between China and Taiwan. The primary worry is the potential for a conflict or invasion of Taiwan by China. I am acknowledging this risk, though I believe it is way more likely than not that we will not see a strong escalation or anything comparable to the situation between Russia and China. Assuming a worst case that China would invade Taiwan, I would expect an initial sell off in Chinese stocks (though hopefully from a much higher level than today). However, I would not expect the US to enter a war or that we will see economic sanctions by the west comparable to Russia. While Russia’s global trade volume is insignificant, China is about the most important trade partner for most of the world, short term irreplicable.
Investing in the stock market is always subject to risks. Investors in the US face significant valuation risk at this point (in my opinion). In contrast, valuation risk for Chinese stocks is basically nonexistent at these prices. To me, it is always a question of risk/return. I believe Chinese stocks offer a short to mid term potential of 100-200%. This upside does come at the cost of risks, such as the political risk, or the risk that share prices sell off even further. Considering the risk/reward, I am currently holding a 20% position of my total portfolio in Chinese stocks.
Interestingly, 20% in Chinese stocks is not much more than the exposure of the average global mutual fund manager in 2020. A time where at least the valuation risk of Chinese stocks was way bigger than today. Once again, I find myself running against the direction of the herd and I am pretty excited about it. Hopefully it will pay off as fast as my call for German residential real estate stocks last year. Frankly, I believe that the upside is significantly higher with the Chinese stocks this time, though that is also true for the risks. Even if one year ago everybody was convinced interest rates will only go higher, same as Chinese stocks today would only go lower.
Disclaimer: This writeup is not investment advice. I am sharing my research insights and positioning on individual companies for informational and entertainment purposes. In particular, I do not take into account any readers personal financial situation. Please do your own research.