THE CHINESE MARKET
The past few years have not been kind to investors in Chinese stocks. Since its peak in January 2021, the MSCI China Index is now down more than 50% compared to the MSCI Emerging Market Index, which has declined by ~20%. In contrast, the MSCI World Index has risen by almost 30%. While 2021 is admittedly a high starting point, the five-year picture doesn’t look too different.
The reasons for this lacklustre performance stem from the poor recovery of the Chinese economy following the Covid-19 lockdowns of 2020-2022, increasing regulatory uncertainty after a number of crackdowns on private sector businesses ranging from private education to gaming, and lastly, to political uncertainty, with the Chinese Communist Party and President Xi Jinping in particular acting in an increasingly authoritarian fashion.
From an economic perspective, the property market in China is facing a deep recession and consumer sentiment is particularly weak. The stimulus provided thus far has been inadequate to lift the country out of its slump. In the face of rising public debt levels and an ageing population, many market participants are concerned about the longer-term growth outlook.
While we are aware of these risks, there are offsetting factors, including China’s high private savings rate and the country’s technological leadership in multiple end markets. Growth may be slowing, but at 4-5% it is still much higher than in most other countries.
The regulatory announcements on 22 December last year, which included more proposed restrictions on time spent playing online games as well as on in-game purchases, certainly didn’t help investor sentiment. The share prices of NetEase and Tencent plunged 24% and 12% respectively on the same day.
It is important to note that China’s National Press and Publication Administration has since significantly backtracked on these announcements by clarifying that it supports healthy growth in the industry, taking down the draft rules from its website and removing senior officials linked to their development.
While the regulatory environment remains uncertain and we agree that a Tencent valuation discount is warranted, we don’t believe it is the intention of the Chinese government to destroy the private sector – in their quest to become a dominant world superpower, the powers that be recognise the importance of private enterprise.
TECH COMPANY VALUATIONS
In our view, the market has clearly discounted these factors into the share prices of Chinese firms. If one considers the three-year earnings growth outlook as well as the multiples applied to the earnings of large US-listed tech stocks and compares these to Chinese tech firms, the difference is quite stark.
For example, the median analyst expects Microsoft, Meta and Apple to grow earnings at 16%, 16% and 10% respectively per annum for the next three years. At the same time, they are trading at ~32x, ~22x and ~28x forward price-to-earnings multiples respectively. In contrast, Tencent and Alibaba are forecast to grow earnings at 16% and 12% over the same period, yet they are trading at ~13x and ~8x multiples respectively. In Tencent’s case, this drops even further to ~10x if one excludes the value of its large investment portfolio that is still reporting low levels of earnings.
A WORLD-CLASS BUSINESS
We see Tencent as one of the world’s truly great businesses, with a strong management team and some of the best sustainable competitive advantages globally. In fact, no single Western company can compare adequately to Tencent. Its largest asset is its user base of 1.3 billion on WeChat. From this base it earns advertising fees (think Facebook or Google), charges platform fees for apps on WeChat (think Apple or Android app store), earns a take rate on payments (think Visa or PayPal) and provides music and video subscription services (think Spotify or Netflix).
In addition, Tencent is still the world’s biggest online gaming company by revenue (think EA Sports or Nintendo), even though the contribution of gaming to group revenue has fallen from more than 65% a decade ago to around 33% today. It also has a growing cloud enterprise servicing both businesses and individuals (think AWS or Google Drive).
In our view, the runway for long-term growth is decidedly healthy, with Chinese consumers probably growing ahead of the rest of the economy for the foreseeable future. Combined with Tencent’s undermonetised user base, this translates to revenues likely increasing above gross domestic product and profits growing at an even faster rate as margins expand to more optimal levels.
THE BOTTOM LINE
We continue to indirectly hold a stake in Tencent in our clients’ portfolios through our holdings of Naspers and Prosus, with Tencent accounting for more than 70% of the net asset value when using listed prices. While we are cognisant of the China-specific risks, we believe that current market prices more than adequately account for these. We have therefore recently increased our stakes in these shares.
