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Are battered China tech stocks on a long-term rebound?

Kate Lin  |  20 Jul 2022Text size  Decrease  Increase  |  
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This time last year, Chinese stocks began a slide that would ultimately vaporise more than half the value off some of the country’s biggest companies.

But after a brutal year of regulatory crackdowns, trade spats, coronavirus lockdowns and a property market meltdown, Beijing is sending encouraging signals it plans to support domestic companies and ramp up policy support for an ailing economy.

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Share markets are taking notice. In the second quarter, four top performers across Morningstar’s global stock coverage were US-listed Chinese stocks.

While the market may be staging a relief rally, some investors want to see more evidence that the fundamentals have turned in favour of Chinese stocks.

Wenchang Ma, Hong Kong-based portfolio manager at mutual fund company Ninety One, is looking for an "inflection point" where corporate earnings find momentum to swing upward again.

"Market sentiment alone would not be sufficient to sustain a stock rally," she says. "Signs must come from solid real economy improvements, that are able to pass on support to corporate earnings. We are not there yet, but there are early signs that earnings reports are about to find a bottom."

China tech stocks rebound as much as 20% from their lows. JD.com and Meituan lead this round of recovery.

Chinese regulators soften their tone

Helping fuel the recent rally were steps taken in June by China’s State Council, which announced 33 measures aimed at jump-starting the economy after months of lockdowns in parts of the country.

Later in June, in a sign that government regulators are loosening their grip slightly, truck service provider Full Truck Alliance (YMM) and online recruiting platform Kanzhun (BZ), both under a data security probe, received greenlights from the country’s cybersecurity watchdog to resume registering new users for their platforms. Authorities have also resumed approving mobile game titles after a nine-month freeze.

One of the biggest pieces of positive news for the group were reports that China’s central bank has accepted the application for a financial holding company license from Alibaba’s fintech arm, Ant Group, which may also pave the way to revive its suspended IPO, once tipped to be the biggest of all time, with the goal of raising more than $30 billion.  

It remains to be seen whether the policy relief can lead to a continued stock market recovery amid a new outbreak of the omicron variant of the coronavirus, which in turn has led to rolling lockdowns in critical hubs like Shanghai and Shenzhen.

Despite this, the policymakers’ softened tone has been felt across the stock market. After falling 53% from a recent peak in February 2021, the Morningstar China Index has risen 12% since hitting a mid-March low.

For individual names, the gains have varied. Tencent (TCEHY) lagged in the wave, while JD.com (JD), Meituan (MPNGF), and Pinduoduo (PDD) have already bounced 20% from their respective lows.

Chinese equities rallied in the second quarter, but year-to-date index return remains in the negative territory.

 

Is the market primed for yet another China bull run?

After the bounce, many market-watchers say the worst of the regulatory reset is over, but risks with long-term fundamental implications remain.

"A gradual recovery of stock valuations mostly reflects a loosening of regulatory impacts, but macro headwinds still exist," says Ivan Su, senior equity analyst at Morningstar. For example, while Shanghai ending its lockdown in June, the country has yet to turn its back on its zero-tolerance mindset to Covid-19.

As China records its first cases of the new omicron variant, "uncertainty remains on how the government handles (the new variant)," Su says. "Restricting people’s mobility will certainly be a blow to consumer confidence and the operation of some companies."

He said, for example, lockdowns in Shanghai forced the suspension of e-commerce platform JD’s warehouses, while ad sales-driven internet firms like Tencent were also under pressure because of muted consumption sales.

In Su’s view, a prerequisite for the rebound in Chinese stocks to continue will be more positive news out of government regulators. 

"A more powerful rebound will come as the authorities end up confirming reports such as completing the cybersecurity review on Didi, or licensing Ant Financial. But it’s very difficult to estimate the timeline," says Su.

Weaker returns may be inevitable

While Ninety One’s Ma remains cautious, she believes the long-term case of investing in China is intact.

For starters, authorities are calling for better policy coordination and more support for local businesses. Some have voiced support for measures to restore market confidence. Thus, Ma trusts that healthy development and growth of the internet companies, including platform economies, remains a goal for the authorities.

Anh Lu, portfolio manager of T. Rowe Price Funds SICAV – Responsible Asian ex-Japan Equity Fund (with a Morningstar Analyst Rating of Bronze), still finds values in China, but the competitive landscape in the e-commerce and the social media space holds her back. She started reducing exposure to the space in the first quarter of 2021.

"We had no great foresight of how much policy will change, but the regulatory cycle coincided with a period where we felt that the competitive environment was quite intense," says Lu. "I don't think it means that these are companies in which one cannot invest. There’s a readjustment process that all these companies are going through."

"We try to not get too myopic to focus on what's happening today, but look at how things would look next year. It comes back to focusing on businesses that we think have as many idiosyncratic attributes as possible so that we're not having to take very strong views of policy, or geopolitics, or whether GDP is going to be 3% next quarter or 5%."

For segments where the penetration rate is already high, such as e-commerce, gaming, and social media platforms, she sides with those with robust business models and management execution ability that allows the firms to monetize at a higher rate, or those that have inroads into new markets.

For categories where penetration rate is not as high, like online recruiting or delivery services, there’s still room to grow. "Once this downturn all settles, we expect the competitive dynamics, in delivery especially, to reduce," she explains.

Tech stocks have attractive valuations 

As pressure on the sector has yet to dissipate, tech stocks remain very attractively priced for long-term investors. Morningstar equity research has two preferred picks: JD and Tencent. Both stocks are trading in a 5-stay range and have wide moats.

Su explains the fair value estimates: "while we can’t predict the next policy move, we have strong confidence that Tencent will be able to navigate these headwinds over time with investments that they are already making today."

"In 2021, we’ve already adjusted valuations to reflect potential regulatory downside to our models, which we think is minimal. For example, Tencent is banned from monetising its games from underage gamers, an area we think has relatively little materiality," says Su.

Our analysts believe JD is a best-in-class e-commerce company and prefer it over Alibaba.

JD has given better clarity on long-term margin improvement. The firm also enjoys a reputation for a highly reliable inventory of genuine merchandise that is readily available, and an efficient and fast proprietary logistics services, which should also help retain higher-end users.

is a Data Journalist for Morningstar Asia, and is based in Hong Kong

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