The Chinese Tech Structural Growth Story

John Leiper – Head of Portfolio Management – 19th June 2020

China’s economy has transitioned, from an industrial export-led model, towards services.

This is evident from the chart below which shows the service sector, in pink, has grown from representing approximately 20% of annual GDP to over 50%.

This growth, in the service sector economy, is driven by growing domestic consumption as indicated by the dramatic increase in China’s retail sales over the last 30 years. This trend shows no sign of slowing and should re-accelerate towards the trend-line following the recent decline as a result of the coronavirus.

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The driving force behind this move is the well-known impact of rural-to-urban migration. This is reflected in the chart below which shows the China Population Urbanisation Rate, in pink, which rose from approximately 20% in the 1960s to 60% in 2018. As more people move to the cities they gain access to better jobs and higher wages leading to the highly correlated rise in GDP per capita, in yellow, which reflects the emergence of a growing and prosperous middle class.

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What is interesting is that, over the last decade, internet usage, in both rural and urban areas, has remained broadly static. This tells us that the key driving force behind increased internet use, in white, is migration. With China’s rural population at 40% there is considerable scope for further migration to urban areas which should further increase internet penetration rates, towards those enjoyed in the US as shown by the yellow line.

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We believe the best way to benefit from this structural growth story is to allocate capital towards Chinese technology companies.

Some of these companies may already be familiar, such as Baidu, Alibaba and Tencent Holdings. The fact they have their own acronym, the BATs, suggests they might be. As a starting point, the easiest way to think about these companies is to compare them to their US equivalent… Baidu is an internet search engine comparable to Google, Alibaba is an e-commerce giant comparable to Amazon and Tencent primarily operates as a social media platform equivalent to Facebook. Broadly speaking, the BATs (plus a few others) are the Chinese version of the FAANGs (Facebook, Amazon, Apple, Netflix and Alphabet – formerly Google).

Whilst US tech companies are arguably closer to saturation point, Chinese tech companies offer greater upside potential due to lower, but growing, internet penetration rates in a rapidly expanding consumer based domestic economy. This is reflected in higher revenue and earnings growth as demonstrated below when comparing Alibaba (in pink) to Amazon (in yellow).

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Chinese tech valuations are also relatively attractive, particularly when looking at the price-to-sales ratio of US listed Chinese technology companies. As shown in the chart below, these ratio are now showing signs of rebounding from record lows.

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Over the last few months, the coronavirus has fast tracked the existing transition, towards the internet-of-things, resulting in increased demand for remote working IT solutions, online education, gaming and other e-commerce services. We think many of these developments are here to stay and as a result, we recently added a new position tracking the CSI Overseas China Internet index. We have wanted exposure to this theme for some time but had been unable to do so until now due to the lack of available European-listed ETFs of sufficient size and liquidity.

As shown in the chart below, Chinese technology companies have outperformed both mainland Chinese companies, in yellow, and broader emerging markets, in pink, offering resilience through the downturn and upside thereafter.

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There are a number of risks to this trade idea, such as the recent Luckin Coffee accountancy scandal which re-kindled trust and accountability concerns in Chinese firms in general. Further, the increasing dominance of Chinese technology companies, and a growing backlash against China, as the origin of the coronavirus, is leading to renewed political tension with the US and talk of a new cold war. This has culminated in attempts to force US investment companies, such as BlackRock, to divest holdings in US-listed Chinese companies. At the end of May, the Senate passed a bill that threatened to ban Chinese securities from US exchanges if they cannot demonstrate adherence to strict regulatory and auditing standards. Such politically motivated actions have weighed on share prices despite otherwise positive fundamentals.

We believe such policy will likely spur more US listed Chinese companies to add secondary listings in Hong Kong, like that already undertaken by Alibaba last year. The motivation for doing so is to avoid the obvious negative sentiment and better align investors and share prices with the underlying business. We see two positive developments from such a move. These relate to the ‘Stock Connect’ program and potential inclusion in Asian and Hong Kong stock indices.  

The Stock Connect program, launched in 2014, was designed to create new trading links between Hong Kong and mainland China thereby opening capital markets to a whole new pool of potential investors. Recent revisions to Stock Connect rules now allow companies with dual-class shares to be included in this program. Chinese technology companies typically prefer dual-class shares as they provide founders with greater voting rights and ongoing control after IPO. Recent examples include Meituan Dianping, an on-line Chinese delivery company, and smart phone company Xiaomi, which were included in Stock Connect in October 2019 and have since seen their share prices rise in value relative to peers. We believe other companies will follow suit.

In May, a similar revision to rules concerning companies with dual-class shares was made regarding constituents of the Hang Seng equity index. Starting in August, large-cap tech firms, like Alibaba, Xiaomi and Meituan Dianping, may now be eligible for inclusion in this index resulting in large benchmark-driven inflows which are share price positive.

Despite the risks, in a low growth environment, structural growth stories, like Chinese technology companies, are an attractive proposition and this theme will likely form the corner stone of our emerging market equity exposure going forward.

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.