China’s Internet Stocks Are Like Buying US Tech Before Covid

I don’t know if you’ve heard, but China is killing it. Here’s a quick rundown of things you should know:

  • China is the world’s only economy that grew during Covid. After pulling off a “V” recovery, it’s expected to grow a strong 8.6% in 2021.
  • For the first time in history, foreign investments (FDI) in China have surpassed the U.S. 
  • Meanwhile, Wall Street analysts are the most bullish on Chinese stocks in a decade. Bloomberg data shows that ~86% of all ratings in CSI 300 Index (the S&P 500 of China) are a buy. That’s more than anywhere else in the world.

And if you invest in internet stocks, your mouth might start watering because I’m about to show you something startling. Here’s a chart that stacks up the valuations of China’s and America’s internet stocks:

As I wrote in Meanwhile in Markets last week, China is like Target TGT on Black Friday for tech investors. By valuation, China’s internet names are where their US peers were during the Covid crash. But as with all good things in life, there’s a “but.”

China began roasting its internet giants

Last November, the Chinese government started picking on its biggest internet companies.

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First, it dealt a heavy blow to Ant Group, a fintech giant and one of China’s biggest tech companies. After meeting with its billionaire founder, Jack Ma, China scrapped what was supposed to be the world’s biggest IPO—valued at $35 billion.

Then it unveiled a broader plan (still in draft form) to tighten the screw on tech monopolies and internet services.

It didn’t take long before investors fled China’s internet stocks. In just two days, the biggest tech names shed ~$200 billion in market value and have not recovered. Take one more look at the chart from above:

China’s internet stocks don’t usually sell for cheap. Since 2017, their valuations hovered above their American peers most of the time. But today they are nearly twice as cheap. Heck, their valuations have even sunk below the conservative S&P 500.

(For those who don’t know, forward P/E is one of the most popular valuation metrics—which weighs a stock’s price against its expected earnings over the next 12 months. It’s calculated by dividing the share price by forward earnings per share.)

The risk is still here, though. Nobody knows what China is going to do to rein in its internet companies. And unlike Congress’s tech roastings here, you won’t see Jack Ma sweating bullets in front of regulators on TV. Much of China’s decision-making will happen in the usual fashion—that is, off the record.

So the main question is: are Chinese internet stocks worth the risk of the unknown?

The Chinese crackdown might turn out for the better

From talks on Wall Street, it seems that investors might be laying it on thick. And that this is more of a transition from a regulatory “Wild West” to healthy antitrust laws. After all, Chinese regulators haven’t probed a single deal in the internet sector. Ever.

“We think that they’re likely now trying to understand how to properly regulate the internet, e-commerce, broad tech industry. Once they resolve that, the risk should be lessened,” said Alex Wolf, head of investment strategy for Asia at JPMorgan Private Bank

Some of the JPMorgan analysts even put a positive spin on China’s crackdown. “Those additional rules will ultimately help Chinese internet companies grow in a sustainable way — and will not likely dash their growth prospects,” they said in a recent note.

Now, if things do go wrong, a lot of bad scenarios might already be baked into the stock prices. In a report I received from UBS, Jerry Liu, UBS’s China Internet analyst said: “Regulation is the hot topic, and the good news is we believe the near term risks are priced into most stocks.”

So while there’s still a lot of uncertainty, Chinese internet names look like a great addition to a tech portfolio. And there are two ways individual investors can invest in them.

The easiest, set-it-and-forget-it way is to buy a broad ETF tracking China’s internet stocks. There’s only one fund that tracks a basket of Chinese internet companies instead of the broader tech sector. It’s KraneShares CSI China Internet ETF (KWEB) KWEB .

Another way is to look into individual stocks. Here’s a quick run-through of promising areas on the Chinese internet—along with top Wall Street picks.

Short-form video platforms

No matter where you stand in the love-hate debate on TikTok, short videos are taking over the internet. I know, TikTok’s lip-sync videos might seem like a passing trend. But in China, these kinds of shorts are the #1 video format people watch online.

To illustrate, here’s a breakdown of online video consumption in China by video length:

For investors, short video should be attractive for more than just the number of eyeballs it draws. Social networks built on this format are also way better at making profit from those eyeballs.

First, their algorithms do a better job serving ads. Take a look at this chart. It shows how China’s TikTok (Douyin) can make more ad dollars (oh, yuans) per user than the rest of the top Chinese platforms:

Second, these platforms are more flexible and adept at monetizing content. They often make money in multiple ways, such as e-commerce, ads, subscriptions, and even tipping/virtual gifting during live streams. (Yes, that’s a thing now.)

“Short video can leverage most monetisation methods. Compared to social networks like WeChat, we believe short video users are more comfortable with seeing and interacting with monetised content,” said UBS’s Jerry Liu.

The thing is, Douyin is owned by ByteDance, which is a private company. But the world’s second-largest short video platform, Kuaishou, is IPOing in Hong Kong next week. It’s going to be listed under the (HKG: 1024) ticker.

Mobile gaming

There are two reasons China’s mobile gaming sector stands out right now.

For starters, China’s watchdogs aren’t picking on the gaming industry. And JPMorgan strategists think it’s a great way to invest in China’s internet while its government is figuring out how to regulate it.

“In terms of positioning, to circumvent the regulatory overhang on e-commerce in the coming months, we favor the online gaming industry on the back of its resilient growth prospects,” they wrote in a recent report.

(JPMorgan’s top gaming picks in China are: Tencent (HKG: 0700), NetEase NTES , Archosaur Games (HKG: 9990))

Then, China’s mobile gaming companies are revamping the way they distribute games. In short, they are quitting app stores in favor of selling games through social media (like WeChat) and other digital channels.

According to UBS data, Chinese gaming companies now pull in nearly half their sales this way. That’s big. Because UBS’s analysts estimate that in the long run this model will grow the shelf life of mobile games and earnings.

The challenge here is that you need a strong brand and resources to put out games independently. For this reason, UBS favors bigger game dev companies that ship first-rate games.

Their top gaming picks are: Tencent (HKG: 0700), Perfect World (SHE: 002624), Wuhu Shunrong Sanqi Interactive (SHE: 002555).

E-commerce

And last, e-commerce. If you think people are getting used to shopping online here, take a peek at China. By 2023, online shopping is expected to make up nearly 40% of all retail in China. By these numbers, the U.S. is barely dipping its baby toes, as you can see below:

UBS strategists think groceries (and especially fresh food) will be the two fastest-growing pockets in China’s e-commerce. Their top picks in this sector are Alibaba BABA (BABA), JD (JD), and Vipshop (VIPS).

Maybe it’s time to move some of your “internet eggs” to China

Keep in mind that America’s internet giants are not off the hook. Here’s a list of fresh lawsuits that were buried under Covid headlines:

  • On Dec 17, 38 states sued Google GOOG for holding a monopoly over internet search
  •  That’s on top of the suit from 10 states accusing Google of running a digital advertising monopoly
  • On Dec 9, the Federal Trade Commission joined 46 states suing Facebook (FB) for buying out competition
  • And after a lengthy investigation, House Democrats recently concluded that Apple AAPL and Amazon AMZN are abusing their power over third-party partners

With a Democrat-led Congress, tech giants now have a big, blue antitrust target on their backs. Maybe even bigger than Jack Ma does. And it’s probably a matter of time before regulators start shaking up tech over here.

So if you invest in the internet, it may not be a bad idea to follow smart money and move some of your “internet eggs” overseas. Meanwhile, keep a close eye out for:

  • China’s wrap up of its regulatory guidelines (as well as fines and rulings that could follow)
  • Where the US-China affair is heading under Biden. Most important are policies that could delist Chinese stocks from US exchanges and otherwise bar investors from investing in them.

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