China internet: Identifying opportunities amid stormy seas

Exogenous challenges and faltering growth

In our view, there are three key risks weighing on Chinese internet companies: geopolitics, local policy, and slowing growth. 

The geopolitical climate has proved challenging for tech companies in China. With the Biden administration’s additional restrictions on semiconductor and semicap equipment sales to China, progress in advanced tech, such as AI or autonomous vehicle development, is potentially impacted. While domestic relative competitiveness will likely go unaffected, the restrictions may make it more challenging for Chinese companies to enter foreign markets — especially in areas that require high compute power, like cloud computing, a byproduct of being unable to access the most advanced hardware.

Greater geopolitical tension could also make foreign investors less likely to buy Chinese stocks. There may be a future where ownership of China tech companies listed offshore shifts to local shareholders, but this would take time. Alternatively, companies could relist in the A-share market, but, in my view, this could also be challenging.

Aside from geopolitics, there are also local policy risks. On one hand, the government is weighing support for the economy as it shifts toward a new model for economic development. Potential stimulus would benefit any company, but on the other hand, the focus on common prosperity and the wealth gap is a tail risk for internet and high-growth tech companies. In my view, profits are likely to be more cyclical and margins capped. In fact, we believe that some companies may self-impose such constraints to get in front of potential regulatory scrutiny. 

Against this backdrop, it’s possible that certain tech subsectors — such as entertainment industries like video games and streaming — could be more vulnerable than others that are deemed to contribute more strategic value. These industries could see unexpected, material risks appear unannounced, like they did last year in this sector.

Finally, we think there is also reason to be skeptical about Chinese internet companies’ growth potential as an industry at this point. Penetration rates in the internet-services space have grown significantly. Competition generally remains high — although less cutthroat — with better rationalization. While there is room for growth ahead, it will most likely slow down compared to previous years. Investors will need to assess whether the growth profile of companies in this industry remains attractive enough to discount issues such as variable-interest entity (VIE) structures, policy impact, and geopolitics.

What’s the bull case? 

While our bear case is rooted on a dimmer outlook for the industry, the bull case is rooted in something more immediate — valuations. By almost any measure, Chinese internet company stocks are attractive. In the short term, policies around economic opening and stimulus will be key drivers for stocks as sentiment is very low. Potential government stimulus could make the investment case more attractive. A rising tide could lift all boats, but investors may wish to consider which areas of the market could benefit most from policy change.

Low valuations also suggest that the market could reassess the multiples for certain businesses as investors turn more positive. Changes here could have meaningful upside; companies are flush with cash and are returning capital to shareholders. 

In our view, one of the best possible outcomes for Chinese internet companies could be policy change. It’s possible that China is overdue for some policy support, and we wonder whether the current COVID-containment policy might eventually ease up. There have already been some policy changes, including shortened quarantine periods, loosening up some travel restrictions, eliminating the need to identify secondary contacts, and rumors of a gradual reopening.

We’re most optimistic on e-commerce and local services benefiting from potential stimulus. Software companies could also be reasonably well positioned for longer-term growth as potential benefactors of domestic substitution. 

Bottom line on investing in China

It’s important to acknowledge that, when it comes to investing in Chinese internet companies, there are several potential sticking points, but it’s also critical to acknowledge opportunities that exist. Within this space, there are attractively priced companies that are exposed to potential stimulus or the reopening of the broader economy. 

Taking a tactical approach, seeking out specific stocks with attractive valuations and setup, rather than taking broad-based exposure, is, we believe, the strategy to navigate a volatile investment environment.

With so many nuances at play here, in our view, investors seeking exposure to China should remain nimble and may benefit from working with an active manager able to evaluate the complicated political and economic landscape holistically.