China’s statistics are often larger-than-life but the numbers relating to mobile phone ownership and money spent online are truly staggering.
As of the end of last year, more than half the population – some 731 million people – were online. That’s almost all the people in Europe. Some 95% access the internet via mobile devices.
Last year’s Single’s Day – China’s answer to Black Friday or Cyber Monday – saw consumers spend the equivalent of some US$20 billion within a 24-hour period. That’s more than the GDP of Iceland.
China, it seems, is leading the world in the adoption of financial technology. This goes some way to explain why Chinese companies that are benefiting from this explosive growth have been the focus of so much investor interest.
For example, the Hong Kong-listed shares of Tencent Holdings have more than doubled since the start of last year, and have risen around 70% year-to-date. Tencent transformed ‘WeChat’ from a simple instant messaging service into a digital wallet and mobile shopping platform, where registered users can pay for everything from taxis to insurance policies.
Radical changes in the way Chinese consumers behave mean services now account for more than half of China’s economic output. Although state-backed heavy industries are systemically important and provide employment for many millions of people, the fastest growth is found in the private sector where regulations are less stifling and domestic consumption generates opportunities.
Foreign investors have been enthusiastic supporters of companies such as Tencent and Alibaba, whose shares trade in Hong Kong and New York, respectively. The investment rationale is compelling, and sentiment towards technology firms hasn’t been this good since the dot.com era of the late nineties.
In fact, the information technology (IT) sector – led by Tencent and Alibaba – was the biggest driver of gains made by the MSCI’s Emerging Markets index in the first half of this year. The industry accounted for more than half of the 18.6% advance over the period, and is now a heavier weighting in the benchmark than financial stocks.
But investors are exposed to significant risks. These companies don’t come cheap, even compared to many of the household names whose stocks have helped drive US markets to record levels.
Tencent’s Hong Kong-listed shares are trading at nearly 50 times earnings. Meanwhile, Alibaba shares in New York trade around 60 times. To put these numbers in context, shares of Facebook, Google, and Apple trade at some 39, 30 and 18 times, respectively. However, Tencent and Alibaba look like bargains next to Amazon and Netflix on multiples of more than 247 and 213 times.
But even as China’s ‘new’ tech firms take centre stage in the emerging markets, it’s a couple of well-established companies in South Korea – Samsung Electronics and SK Hynix – that are delivering the lion’s share of earnings within the IT sector. Their latest results are primarily responsible for an upward revision of earnings forecasts for IT firms in the MSCI Emerging Markets Index.
China’s technology companies have become a vital part of the economy and this has forced us to reassess the way we view them. One of our long-standing objections has been the use of so-called variable interest entities (VIEs) – unconventional corporate structures designed to circumvent rules prohibiting foreigners from owning stocks in the country’s internet companies.
The position of Chinese law towards these offshore structures is still unclear; furthermore, foreign investors only own a stake in the VIE which gives them a claim, through a series of legal contracts, to the cash flows of the operations in China. By investing in these companies, foreign investors are placing their faith in the Chinese legal system to recognise their rights in the event of a dispute.
That said, the biggest of these companies are now so important we think the authorities are unlikely to risk destabilising them by ruling on VIEs in a way that is detrimental to foreign investors. These companies have, in fact, become ‘too big to fail’.
While we’re still not entirely comfortable with the use of these offshore vehicles, we can appreciate why they are sometimes necessary. We are also more receptive to mitigating factors, such as a track record of treating minority shareholders fairly. This means, one day, one of our regional fund could make an investment in a Chinese technology firm. In fact, the fund managers behind our China portfolio approved a small investment in Tencent earlier this year, in what may turn out to be a test case.
In China, they say you can buy anything on the web. This is partly a testament to how fast the country has changed in such a short time. However, we’ve found that buying the companies that have enabled this revolution has been less straightforward. We hope, in time, this will also change.