By Cornelius Zeeman & Jacques Haasbroek,
Fairtree Portfolio Managers
Recent market performance.
Chinese shares have been known for their volatility and the momentum-driven nature of their equity market. The Chinese technology sector has been no different and suffered a severe derating over the last couple of years. As shown in Graph 1 below, the Chinese technology names started on an equal rating to the Nasdaq on 1 January 2020. The Nasdaq however rerated 19% from that point, while the names below derated 59% on average.
Graph 1: Forward price/earnings ratio
Source: Bloomberg
This derating has been driven by various factors, including the ongoing property market crisis, rising geopolitical tensions with the United States, depressed consumer confidence and regulatory uncertainty. This last point was again illustrated by the draft rule on gaming released before Christmas, which was subsequently retracted.
Uncertainty is not good for markets, and the Chinese equity markets have seen substantial outflows from investors. The current ratings are more extreme when you consider the balance sheet strength these companies have built over recent periods. Graph 2 below shows the cash and cash equivalents these businesses have amassed in the context of their current market capitalisation, with the likes of Alibaba and JD.com currently around 53% and 76%, respectively. This highlights the cash-generative nature of these businesses and the improved capital discipline by the management teams in recent periods.
Graph 2: Net cash as a percentage of market capitalisation as at 16 February 2024 (US dollar)
Source: Bloomberg
From an operational perspective, these businesses have continued to deliver and even outgrew the earnings of the Nasdaq. This is despite the fact that Chinese regulators have been tightening their control over these companies. Graph 3 below shows that Tencent nearly tripled its earnings since 1 January 2017, with the earnings of Alibaba having increased 169%, compared to the Nasdaq’s 157% increase. The earnings growth of JD.com and Pinduoduo have been even more impressive as they scaled from breakeven businesses. The underlying business momentum of these companies looks robust and further highlights the valuation discrepancy between Chinese technology and their peers in the United States.
Graph 3: Cumulative growth in earnings since 1 January 2017
Source: Bloomberg
Capital allocation developments.
Another key consideration is the improvement in capital discipline and management returning capital to shareholders. Share buybacks have increased dramatically, with Alibaba returning more than US$10 billion per year to shareholders through share buybacks and dividends as illustrated in Graph 4. In Alibaba’s latest quarterly result, they increased the buyback programme by another US$25 billion, and the management now has the authority to buy back a further US$35.3 billion of their shares. This is a meaningful return of capital when considered in the context of a market capitalisation of approximately US$188 billion on 16 February 2024. Alibaba has not been the only one to increase their share buybacks, with both JD.com and Tencent stepping up their buyback programmes and BYD exploring it.
Graph 4: Alibaba capital returned per year (US$ billions)
Source: Bloomberg, Alibaba company data
Looking forward.
Chinese household savings remain high; however, as a result of the economic uncertainty, consumers have been more hesitant to spend excess savings, as reflected in the core operational metrics reported in recent quarters. Although the economic growth outlook remains uncertain, the Chinese government has implemented policy support to stabilise the property market and economic growth, which should start filtering into the economy and improving the growth outlook. We have also seen a flurry of monetary stimulus announcements.
In the medium term, we believe these Chinese technology and internet businesses are well placed to capitalise on the ongoing transition of the Chinese economy from manufacturing to consumption-based. Added to this, the balance sheets of these businesses are stronger than they’ve ever been, and management teams are unlocking value for shareholders by returning cash through substantial buyback programmes at depressed valuation multiples. This sets the scene for an attractive risk-reward ratio for investors willing to stomach the volatility going forward.
Disclaimer:
Fairtree Asset Management (Pty) Ltd is an authorised financial services provider (FSP 25917). Collective Investment Schemes in Securities (CIS) should be considered as medium- to long-term investments. The value may go up as well as down and past performance is not necessarily a guide to future performance. CISs are traded at the ruling price and can engage in scrip lending and borrowing. A schedule of fees, charges and maximum commissions is available on request from the Manager. A CIS may be closed to new investors in order for it to be managed more efficiently in accordance with its mandate. Performance has been calculated using net NAV to NAV numbers with income reinvested. There is no guarantee in respect of capital or returns in a portfolio. Prescient Management Company (RF) (Pty) Ltd is registered and approved under the Collective Investment Schemes Control Act (No.45 of 2002). For any additional information such as fund prices, fees, brochures, minimum disclosure documents and application forms, please go to www.fairtree.com.
