Are Battered China Tech Stocks Out of the Woods Yet?

The second quarter marked a significant change in fortunes for many Chinese stocks when compared with a brutal previous year. That was a time when China stocks, including such well-known names as Alibaba Group (BABA) and Baidu (BIDU), suffered big share price declines. Especially hard-hit were online education companies, which saw most of their share-price worth wiped out last year and in the early part of 2022.

The catalysts were coronavirus and regulatory crackdowns. Last year, Chinese regulators launched a multitude of new rules against internet and e-commerce firms and education services providers, leading to the shares slumping deep into bear market territory. Then came a spat with U.S. regulators that threatened some companies with delisting from U.S. exchanges. As if that wasn’t enough, aggressive COVID-19 lockdowns hit the Chinese economy.

In the past six months, though, Beijing has sent signals to support domestic companies and ramp up policy support for the economy in the wake of lockdown-depressed economic data.

As a result, in the second quarter of 2022, four top performers across Morningstar’s stock coverage were Chinese ADRs.

While the market may be staging a relief rally, some investors want to see more evidence that the fundamentals have turned in favor 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 could 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.”

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, also 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 link 1012474 suspended IPO debut, which was set to be the biggest IPO of all time, 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.

Which China Stocks Have Rallied the Most?

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.

Is the Market Primed for Yet Another China Bull Run?

After the bounce, many market-watchers say the worst of a 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 From Here 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 coordination on policy announcements and implementation of support for local businesses, and has also been repeatedly voicing its support for market confidence. Thus, Ma trusts that healthy development and growth of the internet companies, including platform economies, would still be something the authorities encourage.

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. 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,” says Lu, who is “more cautious” about the tech sector’s earnings trajectory.

“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.

One of the aftermaths of the regulatory reset is that tech firms will have to realign their business strategies. But this will not be the only thing that has to be adjusted—investors will also need to temper their expectations about the sector’s returns.

Schroders’ Asia equity team believes that a lower return on invested capital is likely to be the result of the new regulations. Tech firms will have to direct investment into key sectors that are considered a priority under the “dual circulation” strategy. Also, operations will face higher costs from paying higher salaries to workers and aiding physical retailers by e-commerce players. Despite a changing ROIC profile, Schroders’ Asia equity team believes companies with a sound business model and good cash flow potentially stand out, given the valuation level turns “much more reasonable.” According to Morningstar Direct, Schroders’ Asia equity team oversees strategies such as Gold-rated ISF China Opportunities Fund and Silver-rated ISF Emerging Asia Fund, both managed by Louisa Lo.

China Tech Stocks Are Trading at Attractive Valuations 

As pressure on the sector has yet to dissipate, the tech stocks remain very attractively priced for long-term investors. Morningstar equity research has two preferred picks: JD and Tencent. Both stocks warrant top ratings in valuation and economic moat, trading at a price below our 5-star price. Formerly referred to as “Consider Buying,” the 5-star price is the price below which Morningstar analysts consider the stock significantly undervalued.

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 monetizing their games from underage gamers, an area we think has relatively little financial materiality,” says Su.

Our analysts believe that 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.