The weaponisation of stock markets
We think Chinese internet stocks have a perception problem. Beauty is in the eye of the beholder and in this case, the beholder is the traditional western investor.
We’re not talking about smaller, hopeful listings that arose in the frenzy of the past years. We’re talking about blue chips – the Alibabas of this world – suffering from a shortage of investor conviction and a volatile trading pattern.
Our view is that one of the problems facing Chinese companies listed in America is that few investors have firsthand experience of living with these products and services. Few in America use Taobao, stream iQiyi, or watch millions of gamers jamming on Huya or Douyu. So everything they invest in is largely conceptual.
Sure, fund managers travel to China and meet companies, but to have these products and experiences as an integral part of your everyday life is a completely different kettle of fish. Just look at Amazon and Netflix and how these stocks defy gravity. Every retail investor in America and beyond owns them in one way or another (and has an opinion on them).
Familiarity breeds conviction. Even the best of the best, Alibaba, gets buffeted by flows that permeate these stocks on even a whiff of negative sentiment related to China. Despite many having robust underlying business models that fuel the world’s second largest economy, the reality is that these stocks will forever be at the mercy of China’s brand image in the West, especially the multiples accorded to them as long as the price is determined by Western investors. This raises the question of how, if ever, these blockbuster companies can trade at sustainably higher valuations.
We’ve seen what happened to Russian stocks since it became clear that Putin wasn’t playing by the western playbook. For many years, multiples were fairly high and there were token reform efforts. We all remember the days of poster child, Magnit, the superstar retailer that was the benchmark of every emerging market portfolio as it rapaciously grew its footprint. Today, Russian stocks have low multiples and are treated with suspicion. They’re a “tactical” or “cyclical” trade for most managers.
We’ve seen a similar derating of western-listed Chinese names as the trade war has erupted. Alibaba reached an all-time high earlier last year was touted at the time as a contender, along with Apple and Amazon, for the world’s first trillion dollar company. Since then, a blanket derating of Chinese names has affected all and sundry. We likely won’t go back to the lofty heights of the pre-trade war era and it’s conceivable these Chinese stocks could follow the Russia-style de-rating (albeit far worse) and simply become a western investor’s tactical trade, rather than the “core” portfolio position we envisioned they could be. The death of the “core position” is increasingly real for these stocks and their owners.
For companies that were profitable at listing, including Baidu, Alibaba and Tencent, it was never the case of China not allowing them to list on the mainland. Rather, China’s internet pioneers chose to list offshore, particularly in the US. Some say it was due to better liquidity and a more accommodative regulatory platform. For others, it was an opportunity for the founders to externalise their wealth in a stable and safe place, far away from the grasp of the CCP.
Unfortunately, that arbitrage opportunity is wearing down even as we speak. We think there’s a possible path to materially higher valuations in these names, but it will not be for the faint-hearted and could conceivably crimp access for most international investors outside of the Chinese market.
China's end game.
We think what these names need in order to attain blockbuster valuations is a China-centric investor base.
It’s clear this end-game is a long way away, but steps are being taken right now by Chinese regulators to clear a path. Whilst it certainly isn’t the Chinese’s government’s primary objective to raise stock valuations, it doesn’t want foreign investors to reap the majority of the rewards that stem from growth in these companies. The problem is that founders of these entities need capital to be offshore for all sorts of reasons, which we know well.
If the Chinese government has a relevant and feasible platform inside the country to help raise capital for these companies, then budding IPO candidates have less of an excuse to move offshore, nor effectively export billions of dollars beyond China’s borders (or in the case of Alibaba, hundreds of billions).
The issue with current A-share rules is that the listing application process is highly stringent and effectively rules out companies who are not profitable, thus eliminating most emerging tech companies. Furthermore, the current system is approval-based rather than registration-based, leading to IPO approvals becoming an extension of government policy rather than proper market functioning.
For China, there is an excruciatingly fine line to tread between allowing access and managing capital flows – while the country is keen to allow inbound investment, subject to increasingly generous quotas (e.g. A-share quotas moving from restrictive QFII quotas to the more liberal Hong Kong CONNECT system), it’s also wary of the risk of violent redemptions and outflows. Primarily because of these restrictions, MSCI remains reluctant to fully include A-shares in its Emerging Market index.
The proof is in the pudding.
A couple of recent proposals have been touted by Chinese regulators, the technicalities of which we won’t go into here.
Rather let’s look at some examples of what happened when Chinese companies that were listed in the USA delisted and subsequently relisted in China. Consider Qihoo 360, an antivirus/utility software company previously listed in the US as an ADR (QIHU US). After a somewhat disappointing decline in 2014, as the Chinese internet hype died down in the US, the company decided to go private in 2016. From its listing in 2011 until going private in 2016, value grew 5-fold, in-line with earnings growth. Not too shabby. The company's market capitalisation when it went private was US$9.96bn, with pro-forma 2016 revenues of US$2.7bn and net income of US$490m.
Turns out this isn’t the end of the story. Thanks to Ma Rui and Lu Ying-Ying from Techbuzz China, we recently learnt that Qihoo 360 went back to China and was re-listed in 2018 as 360 Security (601360 CH), tradable via HK Connect. While the business has barely grown (consensus expectations are for 2018 and 2019 full year revenue of about US$2-2.4bn and net income between $550-660m), its market cap has ballooned to US$25bn equivalent. That’s a 2.5x expansion in size for a 10% decline in revenue.
Another prime example of a company that found a hero’s welcome when it moved its listing back to China is Focus Media, the advertising company formerly listed as FMCN US, targeted by Muddy Waters as a fraud because it couldn’t reconcile the number of advertising screens reported and those their researchers could locate. The story is similar. Focus Media was taken private in 2013 by a consortium led by China Everbright Group from its US listing with US$927.5m of revenues and US$240m of profits in 2012, for a total equity value of US$3.8bn. Today it trades at US$15.3bn on its Shanghai listing (002027 CH), with US$2.1bn of total revenues and $976m of profits. Turns out Muddy Waters couldn’t have been more wrong – but who could have been sure at the time? It’s easier to target a Chinese company listed in the US than a Chinese company listed in China.
The bottom line is that we don’t know why Chinese investors placed higher valuations on these stocks above their western counterparts. What we do know is that Chinese investors look at different attributes when evaluating a company – at this stage it is unclear exactly to western investors what those are – but that is the point.
A thought experiment.
One cannot help but wonder, if Alibaba was listed in the Chinese mainland, could it foreseeably be the most valuable company in the world? It currently has a market capitalization of $490 billion. What multiple could we apply to this in light of a domestic listing? Making the case for Alibaba’s candidature in the US$1tn+ market cap club is by no means a long shot. Just this week there are media reports of a potential secondary listing for Alibaba in Hong Kong. Pundits point to trade war tensions as the driver, but the reality could also be a more profound (and practical) objective of improving valuations by listing in a friendly venue.
Alibaba’s rumoured dual listing came hot on the heels of SMIC’s announcement of an actual decision to de-list its ADRs from New York, with the Chinese semiconductor manufacturer pointing the finger at onerous regulatory requirements as the key driver of their decision. Whatever the reasons behind the shift in attitude, the end point is the same: Chinese companies are looking to go home.
They will likely be in good company. There has also been much noise that Bytedance, the behemoth “Real AI” company that’s currently the world’s highest valued private enterprise, is being aggressively nudged into the spotlight as the first blockbuster domestic IPO in order to boost the credibility of the new Chinese Science and Technology Innovation exchange.
An onshore listing also offers a starkly different paradigm as far as valuations are concerned. Our favourite “Real AI” idea, iFlytek, trades on a historic PE of over 90 and has done so for many years. If it traded in America, it certainly wouldn’t be anywhere near that. Chinese investors (at this stage still overwhelmingly retail) don’t see the world through the same eyes as traditional Western investors. 5000 years of a parallel civilisation’s tastes, preferences and priorities are completely different and this cultural divergence is everything.
Governments have found a new trick.
To make things worse, governments have now found a new trick: the weaponisation of stock markets. With capital ownership intertwined between the US and China, both sides are looking at increasingly destructive ways to bend the other to its whim. Both economies are profoundly interdependent, but when it comes to the stock market, the relationship is more one-sided. Many Chinese companies are listed in New York, but no American companies are listed in China.
This imbalance does not directly translate to one side being at an advantage. On the one hand, it’s not impossible the US government calls foul on the VIE structures used for many US listed Chinese names and penalises these companies, punishing equity valuations and cutting off a source of capital. Nor is it inconceivable that the Chinese government instructs its companies to leave western investors carrying the bag through their own dexterity with the same VIE structures.
The latter is potentially more lethal to the US than the former is to China. A single judicial ruling in China that the transfer of economic interest to offshore investors through contractual arrangements via VIEs is illegal and prohibited is all it would take to turn the collective market capitalisation of all the US-listed Chinese companies to zero, with shareholders laying claim to a shelf filing in the Cayman islands rather than a Chinese internet behemoth.
One thing’s for sure: higher risk was never a contributor to higher asset valuations, and we are facing ever more idiosyncratic risks.
An active imagination.
It’s all in the mind when it comes to valuations. Fundamentals are just one part of the picture. Between them and the share price sits the multiple, and the multiple is, to all intents and purposes, sentiment driven. Ignoring the mindset of investors and the relevant market is a recipe for trouble.
As investors, we have spent years trying to understand the mentality of Chinese investors and have developed some ideas of what the differences are, but a lot remains simply indeterminable. All we know is that prices are made by those who are active in the market, and if companies can attain better valuations by moving to China, all things being equal (we agree at this stage they are not) why wouldn’t they?
What is clear is that the Chinese government would very much like to keep the champions of the future as close to home as possible – and the capital that comes with them even closer. It might take time, but we only see this evolving one way. If events pan out as we expect and domestic listings proliferate, we expect momentum to gather pace quickly. Early signs are promising, or ominous, depending on how you look at it.
Investors with the stomach to position for the tipping point could experience career-defining performance. Those who don’t, might come to wish they’d had more faith in Chinese capital markets, and more active imaginations.