TCEHY - KWEB: Is It Different Now

2023-12-25 11:57:16 ET

Summary

• The KraneShares CSI China Internet ETF has experienced significant losses due to the government crackdown on capitalism in China.
• The ETF has underperformed major Chinese indexes and other emerging markets, raising concerns about the risk-reward equation.
• Despite high growth potential and attractive valuations, the lack of confidence in the rule of law and government interference make the ETF a Hold.

Summary

China and the Internet, for a long time, were synonymous with exceptional growth and stock price performance. That came crashing down as the pandemic and more importantly, the government cracked down on capitalism to curtail the growth of some of its more liberal companies and entrepreneurs. The KraneShares CSI China Internet ( KWEB ) has given back everything plus some since its inception 10 years ago. Is the worst over, are Chinese internet stocks cheap, and what is the potential upside?

Using consensus estimates for 99% of the KWEB holding I calculated a 47% upside potential based on EPS growth of 19% trading at 12x PE on YE24 estimates. However, the risk of negative surprises makes this ETF speculative.

Performance

I ran several performance filters for the KWEB. One compares it to the major indexes in China, the Hank Seng (Honk Kong) and Shanghai. It seems the KWEB is far more volatile and has underperformed the broader Chinese stocks. The second comparison is China vs a few other emerging markets. Here the results are disappointing with China down the most while India and Mexico are the best performing. The key question to ask oneself before investing in KWEB is if China can provide a suitable risk-reward equation.

China Inc

While the growth of the Chinese economy is extraordinary and has created a plethora of corporate investing opportunities in the domestic market or as an export base, the stock market investor has not fared so well. There are several reasons for the disappointing China equity story. First is a lack of confidence in the rule of law, if or when regulations change that may hinder a business there is no recourse, no due process and this creates uncertainty that warrants a substantial valuation discount at best. Another factor is the opaque nature of many Chinese-listed companies with poor disclosure, a lack of investor relations or accessibility to management via quarterly results calls etc. And finally, it has been my experience that many Chinese companies simply do not operate to maximize shareholder returns for minorities. We investors may have overlooked the fact that stock markets under a communist or dictatorial regime are likely to function under another set of priorities.

Portfolio Overview

Using consensus price targets, I calculated a potential upside of 47% for KWEB. The market has very high expectations for almost all the stocks in the portfolio. However, this has been the case for several years with disappointing results and continued risk aversion driving valuations lower. Alibaba ( BABA ) and Tencent ( TCEHY ) have been the poster child of this derating. Of the top five weights, PDD ( PDD ) (formerly known as Pinduoduo) has been the most resilient and is still up 5x in the last 5yrs.

Revenue and Margins

The KWEB portfolio sports high-growth stocks with consensus revenue running over 15% on expanding EBITDA margins. Only a handful of the stocks in the portfolio look challenged according to analyst estimates. Key overweight, PDD has impressive revenue and margin estimates as does Kanzhun ( BZ ) both with NASDAQ listings.

EPS Growth

The portfolio has over 19% EPS growth forecast for the YE24-25 period, which is supported by Revenue and margin expansion. There are a few companies, highlighted in gray, that are in turnaround, struggling, or still in the start-up phase that I took out of the portfolio calculation. One concern is how good, real, or objective is consensus estimates for Chinese companies. It's been my experience that management, accounting, reporting, etc. are opaque.

Valuation

The KWEB ETF looks inexpensive at a .7x PEG (PE to EPS growth) on consensus estimates. The weighted PE is 13x for YE24 with some stocks such as Alibaba at 8x PE and Tencent at 13x PE. I interpret this low valuation as part of the risk of being in China and subject to surprise regulation changes that cannot be appealed. There is scant real due process or objective rule of law that can protect companies from the government, in my view.

Conclusion

I Rate the KWEB a Hold. The consensus estimates paint fast growth and compelling valuation with exceptional upside. The reality is that the consensus has been very wrong due in large part to the substantial uncertainty that the Chinese government can impact business models. This has been born out in the last few years and while valuations are cheap, they can get cheaper until confidence is firmly reestablished.

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