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Investment views

What’s the real story with China’s tech sector?

23 January 2019
Author: Varun LaijawallaAssistant Portfolio Manager, 4Factor

 

Notes from the road

  • My recent trip took me to Beijing and Shenzhen where I attended investment conferences and visited a range of companies
  • I wanted to examine the developments in China’s tech sector and find out whether the business model of enabling consumers to do more, faster, for less still works
  • Peering through our 4Factor lens suggests that the headwinds that faced the three dominant firms Baidu, Alibaba and Tencent (BAT) in 2018 were largely idiosyncratic in nature

  • Varun Laijawalla,
    Analyst, 4Factor Equity

More to life than speed?

“There is more to life than simply increasing its speed” – Mahatma Gandhi

These wise words evidently fell on deaf ears in the case of Isaac Harding, the man with the highly coveted Guinness world record for scoffing the most baos (thirty) in two minutes.1 Chinese companies seem similarly indifferent to this wisdom, given that their business models rest firmly on enabling consumers to do more, faster, for less.

1 A ‘bao’ is a type of Chinese dumpling. This was a truly remarkable feat considering that the previous record was 18 baos, it had stood for six years; and, impressively, the record was broken by an unknown quantity on the bao eating circuit – Isaac was making his debut. You can read the story here.

By the time you finish reading this...

2017: flight of the BATs

One of the distinguishing features of emerging market equities in 2017 was that the advance was driven by just three main areas: technology, China, and the intersection of the two with Chinese internet companies. This trade has unwound in 2018, with a staggering US$259 billion in market capitalisation wiped off from the ‘BAT’ trifecta (Baidu, Alibaba and Tencent)4 – equivalent to the GDP of Bangladesh, or one-tenth of India’s. While some attribute this to ‘mean reversion’, peering through our 4Factor lens reveals a more idiosyncratic explanation. Understanding the unwind requires understanding what drove BATs’ share price rally in the first place.

As effective monopolies shielded from foreign competition by the Chinese government, BATs continue to enjoy outsize returns, significantly and consistently above their cost of capital, a hallmark of high quality companies. Innovation, coupled with rapid user adoption, led to a mushrooming of revenue streams and operating leverage over 2017. Consensus estimates initially underappreciated the power of this phenomenon and the companies continued to surprise to the upside, particularly on revenues, crucial for disruptive internet businesses. This in turn made valuations more palatable, as higher growth expectations translated to larger terminal values.5

One of the distinguishing features of emerging market equities in 2017 was the narrowness of its advance

 

These positive developments eventually led to BATs receiving increasing attention on global stock markets. Examining these stocks with the 4Factor framework quickly reveals why we identified early on the BAT companies as quintessential ‘4Factor stocks’. First, they scored highly on our objective stock screen, which directs our analysts to a subset of ‘good ideas’. Second, through our rigorous fundamental research process we selected them as ‘best ideas’ for our emerging markets portfolios.

2018: what a difference a year makes

Fast forward to 2018 and Alibaba and Tencent have suffered a notable deterioration in the earnings steer, meaning that these stocks have drifted into the ‘low-scorers’ category. One of the strengths of the 4Factor approach is the objectivity that it brings to our investment process through its unbiased scoring system, which in turn helps to trigger more timely and prudent bottom-up analysis.

Our follow-up work on both companies revealed that consensus earnings (and revenue) expectations were overlyoptimistic – a view confirmed by my recent company meetings. This marked a sharp change from previous years where the ‘betting line’ was positively skewed. For Tencent, our concerns stem from the:

  • Emergence of competitive threats to the core Weixin app
  • Maturation of the games business
  • Weaker competitive position that Tencent occupies in new growth businesses compared with those it has historically dominated

For Alibaba, headwinds include:

  • Delayed monetisation of its core advertising business ahead of more stringent regulatory requirements for its merchants
  • Lower-than-anticipated headroom of monetisation versus developed market peers
  • A deterioration in earnings quality as the contribution of investment gains have been rising
We moved underweight on both stocks earlier this year in our emerging market portfolios.

 

As a result, and despite having held large overweight positions that has generated material alpha for our funds historically, we moved underweight on both stocks earlier this year in our emerging market portfolios. Analysts have continued to cut earnings and revenue estimates, vindicating our decision. This represented a significant and difficult decision, but as evidencebased investors we actively seek to avoid falling into behavioural traps such as the ‘endowment effect’.6

Will India also exceed expectations?

After smashing the bao consumption world record, an out of breath Isaac Harding said, “I was aiming for 22, so to get 30 — I’m pretty stoked”.

Surpassing expectations also rang true in the case of China’s e-commerce story in the last decade.

Indian e-commerce, in contrast to China’s, has flown under the radar. Now we wait to see what is in store for India.

“I was aiming for 22, so to get 30 — I’m pretty stoked”.

 

2Singles’ Day or Guanggun Jie is a holiday popular among young Chinese people that celebrate their pride in being single. It is also China’s Black Friday.
3An understatement as this was in 2016.
4Between 01.01.18 and 31.10.18. Source: Bloomberg
5 The value represents what a firm will be worth beyond a particular point in time. The estimate is based on current value, interest rates and projected growth.

All investments carry the risk of capital loss and past performance is not a reliable indicator of future results.

Developing market: Some countries may have less developed legal, political, economic and/or other systems.

These markets carry a higher risk of financial loss than those in countries generally regarded as being more developed.

For further information on investment process, specific portfolio names and the investment team, please see the important information section.

Important Information

This content is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contains statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual outcomes may differ materially from those stated herein.
All rights reserved. Issued by Investec Asset Management, issued January 2019.

Varun Laijawalla
Varun Laijawalla Assistant Portfolio Manager, 4Factor

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