2023-04-03 00:49:25 ET
Summary
- The Alibaba stock split deserves to be analyzed in the context of Beijing's tech crackdown, which considerably eroded the value of KraneShares' KWEB as of 2021, while the Nasdaq-tracking QQQ thrived.
- Other factors favor Chinese tech held by the ETF, which explains my bullish position.
- However, do not expect a rally as there are questions as to how U.S. semiconductor-related sanctions will affect their competitiveness in the longer term.
- Also, given the past modus operandi of the Chinese regulators, some may wait for further signs of improvement before investing.
- Still, with central banks in the Western world having to be careful that the inflation fight does not turn into further stress for their financial sector, this China Internet ETF becomes attractive with Covid reopening and economic growth.
Despite some recent gains, the fall in Chinese tech stocks since the beginning of 2021 has been dramatic with the KraneShares CSI China Internet ETF ( KWEB ) having lost more than a third of its value, dropping from above $100 to around $30 today. This is shown in the blue chart below.
Now, unlike American technology stocks held by the Invesco QQQ Trust ( QQQ ) which has been hit by the tightening of monetary policy, KWEB's stock downside is rather linked to a strong regulatory regime in China.
Thus, this thesis aims to assess whether the recent Alibaba ( BABA ) stock split does not finally constitute the solution to Beijing's tough regulatory stance that investors have been looking for.
Stock Split To Unlock Value and Satisfy Regulators
Coming back to the above chart, investors will note that QQQ only started underperforming (orange chart above) in 2022 after the Federal Reserve aggressively hiked interest rates while Chinese tech was not only impacted by macroeconomic uncertainty due to the Covid lockdowns, but also by geopolitical factors like the U.S. enforcing tougher restrictions for the export of advanced chips to China. However, the overwhelming reason for their underperformance in 2021 was the crackdown on the tech sector including educational institutions having edtech (educational technology) platforms.
An illustration of the degree to which tech stocks were adversely impacted together with the events which triggered them can be gauged from the performance of the CSI Overseas China Internet Index shown below.
Index Performance Vs Events (kraneshares.com)
This index which is tracked by KWEB consists of companies whose primary businesses are focused on the internet and internet-related technology. It suffered from a value erosion after holdings were subject to an unprecedented number of regulatory-related woes like fines, anti-trust, and anti-monopoly without forgetting fintechs ordered to restructure.
Thus, Alibaba’s stock split seems to be aligned with regulators' aims.
The reason is that it will see the company partitioned into six business groups as pictured below, each with the ability to raise external funding and go public. The official reason is that the action is " designed to unlock shareholder value and foster market competitiveness."
Table built using data from (www.cnbc.com)
The Market Reaction and KWEB's De-Risking
Looking at the transaction, this stock split divides each share into six, effectively diminishing its stock price, but, the total dollar value of the shares outstanding (after the number increases with the split) remains the same. Thus, mathematically, the division does not add any real value, but, as per the sum-of-the-parts analysis, a conglomerate with different business segments like Alibaba normally trades at a discount to the sum of its six parts. Thus, with the Chinese company valued more than its market price, investors are enthusiastic.
Thus, the ADR (or U.S.-listed shares) popped up by more than 10% upon the announcement and Alibaba's shares are up by 18.5% during the last five days compared to only 1.51% for the Nasdaq 100- tracking QQQ. KWEB is also up by more than 6% during the same period.
For investors, KraneShares provides exposure to both the ADR and Hong Kong-listed shares, but, due to delisting fears in the U.S-based stock exchanges as of May 2021 on grounds that the stocks did not meet HFCAA (Holding Foreign Companies Accountable Act) compliance, the fund managers has been shifting their asset allocation accordingly. Thus, from a ratio of 44.3%:55.7% in favor of U.S-listed shares in 2021, the ETF is now more skewed toward Hong Kong with 66.7% of overall assets.
Compare HK and the U.S Weight ( kraneshares.com )
Still, with 31% of its overall weight made up of stocks listed in the U.S. stock exchanges, the ETF remains susceptible to further delisting risks, but some progress has been made on this front in August last year in terms of the HFCAA audit agreement.
More importantly, having in mind regulatory risks across the wider tech sector, this proposed change in Alibaba's structure is the most significant reorganization in the company’s history. At the same time, the fact that it is an eCommerce giant with more than a $560 billion market cap as of March 29 (pictured below) suggests that this split into six lower-valued offshoots may go some way in pleasing the Chinese authorities. For recall, one of the reasons for the crackdown which started in 2020 was that some in the private sector had become too powerful according to the Chinese leadership.
Top ten holdings - KWEB (kraneshares.com)
Thus, this stock split, when considered together with media reports that China’s two-year tech crackdown has ended, suggests that the major risk factor that weighed on the market may be over, auguring well for Chinese technology equities.
Furthermore, in addition to regulations, China's sudden U-turn on its zero-COVID policy which essentially brings a defreeze to economic activities like for example retail sales may become the main driver for Chinese equities this year.
Looking Beyond Regulations
Noteworthily, China's decision to shift its economic policy in favor of "growth through domestic consumption " as the top priority for this year during the last Central Economic Work Conference in December 2022 bodes well for equities in general. While there was specific mention of promoting new-energy cars and providing preferential policies to the elderly, there was also mention of supporting real estate developers but without increasing leverage to such a degree to constitute a further financial risk.
Now, bearing in mind that Covid spreads mainly through human contact, technologies like QR code applications on smartphones connected to remote databases enables contactless access to services, the government is certainly aware that technology simply cannot be circumvented. As such, some policies will likely be skewed towards the implementation of the platform-based technologies which KWEB's holdings can deliver at scale. Viewed from this perspective, internet and eCommerce companies may face fewer obstacles in 2023.
Another positive is China's expected 5.0% GDP growth in 2023, which is much less than what the country has demonstrated in the past, but, still qualifies it as one of the few major economies to experience such an acceleration this year. Looking at how this can spill over to the corporate level, historical data shows that both the one-year and five-year average revenue growth rates for Chinese internet companies are higher than their U.S. equivalent.
Comparing of Growth: Chinese tech and their equivalence U.S peers (kraneshares.com)
Furthermore, while China will be growing, both the U.S. and European economies which were already plagued by high inflation now have to adjust their central bank policies in order not to further stress their banking systems. Therefore, even in the worst-case scenario that the full expected Chinese growth is not achieved, the prospect of having exposure to a market where the central bank does not have to juggle between price stability on the one hand and financial stability on the other when adjusting interest rates makes investment in China less risky in relative terms.
KWEB's Suitability Amid Some Words of Caution
In these conditions, investing in KWEB makes sense. Looking across the industry, there is also the Invesco China Technology ETF ( CQQQ ), whose asset under management is well below the KraneShares' fund despite being incepted four years before as shown below. Moreover, KWEB has performed better during the last year with gains of 9.4% but has underperformed when looking at its longer-term three-year performance of -31.1%. Thus, adjusting for a moderate 10% upside, I have a target of $34.3 (31.19 x 1.1) for the KraneShares ETF. I further support my bullish position with data from Morningstar, which shows that KWEB remains undervalued with a price-to-earnings ratio of 19.74x compared to 22.27x for CQQQ.
Comparison of KWEB, and CQQQ (seekingalpha.com)
Therefore, in a reversal of what happened in 2021, KWEB looks poised to recoup back its losses compared to QQQ. However, as I had detailed in a previous thesis , investors are cautioned that the price action will also depend on how its holdings namely Alibaba, Tencent (TCEHY), and Baidu ( BIDU ) manage to continue delivering on fast AI applications while not having access to Nvidia's latest A100 GPUs to build the sort of advanced AI infrastructure which peers in the western world are capable of. Finally, given the modus operandi of the Chinese regulators, some may opt to wait for how the Alibaba restructuring plays out and reverberates across KWEB's holdings.
For further details see:
KWEB ETF: Alibaba's Stock Split Is Positive For Chinese Tech After The Crackdown