China Internet, Are You Sure? or Really Sure?
By Mark Schlarbaum, Head of Capital Markets & Portfolio Manager
for the KraneShares CSI China internet ETF (Ticker: KWEB)
Throughout my career, I’ve found there have been few real investment opportunities that stand out. Yes, there are always trades with the potential to gain (or lose) 20-30%, but that is not what I am talking about. For me, a real investment opportunity means potential for massive gains in percentage terms and long term uptrends, like owning Amazon since the year 2000, shorting the Nasdaq after its sharp rally in 2000, or buying into the stock market in 2009. I learned from working at T.Rowe Price that investing in a company or a theme that has great fundamentals and a huge potential market may present an opportunity for outsized investment returns. I also learned that it is important to be able to look at investments over the long term and invest with conviction.
I believe the urbanization and growth in consumption of the Chinese middle class is an indicator of a great investment opportunity. I joined KraneShares in the spring of 2015 and shifted my focus to the China internet sector and the KraneShares CSI China Internet ETF (Ticker: KWEB). I like this opportunity because I believe that it is still early enough for investors to capture the potential growth trend in the Chinese internet sector. In my experience, most notable stock growths that have taken place followed a similar pattern: the stocks appear expensive at first, experience a 30-40% upward move, and subsequently leave investors feeling like they’ve missed their prime opportunity to buy, when in reality, some of the best gains are yet to be realized. I believe that strength and positive growth are actually indicators of a potential buying opportunity, not an excuse to stay on the sidelines.
My convictions were recently strengthened after listening to Alibaba’s1 2017 third quarter earnings conference call. During the call, Alibaba cofounder and Vice President, Joe Tsai, laid out one of the of the most bullish cases for owning China internet stocks I have ever heard. Alibaba had just announced a 61% revenue increase2, their highest quarter over quarter increase since their initial public offering in September 20143. The call took place just nine days before Singles Day, the largest online shopping event in the world, where Alibaba would once again go on to beat all previous global sales records, nearly doubling the sales of US Black Friday and Cyber Monday combined4. Given this context, I believe the key points Joe Tsai made on the call are especially compelling:
- When it comes to China, investors are prone to “taking snapshots” and “interpreting events in isolation” and not looking at the big picture over a long period of time.
- When considering the last 20 to 30 years of China’s economic growth he states: “in the history of the world there has never been an economy with a massive population of 1.3 billion people that grew in such a sustained fashion over such a long period of time”.
- Over the 18-year lifespan of Alibaba “China’s per capita GDP grew by a compounded annual rate of 14%”. Additionally “the average Chinese citizen is 10 times better off today than in 1999 with per capita GDP growing from $870 to $8,100”.
- China is still developing economically yet it has “some of the world’s most modern infrastructure and the most advanced mobile economy in the world.”
- Finally, Tsai concludes by connecting the economic and demographic potential in China to opportunities for Alibaba, stating “This income growth will translate into a rising middle class characterized by ever-increasing and higher-quality of life and increasing domestic consumption of the middle class. This long-term secular trend bodes well for Alibaba.”
The opportunities laid out by Joe Tsai are not unique to Alibaba. Companies like Tencent5, Baidu6, and JD.com7 are also benefitting from China’s massive population and rapid mobile-driven internet adoption. With the global initiative to implement a wireless 5g standard on the horizon, China’s commitment to technological development may put its internet companies at an advantage over the rest of the world, especially since the Chinese Government has explicitly pushed for 5g development as part of the 13th Five-Year-Plan8.
These characteristics have led to continued fundamental success and price appreciation in China internet stocks over the past year with KWEB up over 50% over this time period (Click here for KWEB's Standard Performance as of the most recent month end). Despite this success, I still believe that we are in the early innings of the game. An important metric I use to support this belief is the Price Earnings to Growth ratio or PEG ratio. The PEG ratio measures what an investor is paying per unit of growth. The formula for PEG is Price to Earnings (PE) Ratio/Growth rate. Generally, PEG ratios that are closer to 1 are considered to be a good value and present good buying opportunities. For example, if you compare FANG* (Facebook, Apple, Netflix and Google) stocks to the BATJ (BIDU, Alibaba, Tencent and JD) stocks for the past 12 months ended 11/30/2017, the BATJ companies’ average revenue growth was 42.6 which is greater than the FANG companies’ average revenue growth of 32.69. The PEG ratio is 1.29 for BATJ and 4.50 for FANG. The FANG stocks have outperformed on price but underperformed on fundamentals. Given the PEG ratios, a rational investor might expect, with all else being equal, BATJ may outperform FANG over the next few years.
Finally, once I identify an investment theme that I believe has a positive growth story and attractive valuations relative to comparable asset classes, I may consider gaining exposure through a leveraged ETF. Leveraged ETFs use financial derivatives and debt to amplify the return of the underlying index. The Direxion Daily CSI China Internet Index Bull 2X Shares ETF (Ticker: CWEB) seeks daily investment results, before fees and expenses, of 200% of the performance of KWEB’s index, the CSI Overseas China Internet Index10. CWEB presents investors with a high conviction method to aggressively invest in the China internet sector.
Based on my experience, the most effective way to create wealth is by betting big on a secular uptrend. CWEB provides investors with an easy way to bet big and participate. For investors who want to invest in this opportunity in a less volatile fashion, I believe KWEB is an excellent option. Either way, we may still be in the early innings of a secular bull market in the Chinese Internet Sector, and investors now have two ETFs to invest in this trend with conviction.
About the Author
Mark Schlarbaum is a Managing Partner and Head of Capital Markets at Krane Funds Advisors as well as the portfolio manager for the KraneShares CSI China Internet ETF (ticker: KWEB). He has been a portfolio manager and institutional equity trader for 26 years, working for T. Rowe Price, Pilgrim Baxter & Associates, and several of his own successful entrepreneurial ventures.
This article is intended for educational purposes only and should not be construed as investment advice. All opinions or views expressed in this article are current only as of the date of this article and are subject to change without notice.
* These companies represent 0% of KraneShares net assets as of 11/30/2017
- Alibaba % of KWEB net assets as of 11/30/2017: 10.36%
- Alibaba Group, Alibaba Group Announces September Quarter 2017 Results, 11/02/2017.
- Asean Today, “Alibaba reaps record high revenue of US$8 billion.” 11/15/2017.
- August Rick, “Singles' Day Has Eclipsed Cyber Monday And Black Friday, But They All Share The Same Goal”, Forbes, 12/03/2017.
- Tencent % of KWEB net assets as of 11/30/2017: 12.77%
- Baidu % of KWEB net assets as of 11/30/2017: 9.01%
- JD.com % of KWEB net assets as of 11/30/2017: 5.75%
- Central Committee of the Communist Party of China, The 13th Five-Year Plan for Economic and Social Development of the People’s Republic of China 2016-2020. Retrieved 12/13/2017. Note: Translated by the Central Compilation & Translation Press.
- Data from the Benchmark Company, LLC as of 11/30/2017. Courtesy of Fawne Jiang, Managing Director.
- CSI Overseas China Internet Index: Represents the Chinese internet companies listed in overseas markets (New York and Hong Kong), in order to measure the performance of the Chinese internet companies listed outside mainland China.
The KraneShares ETFs are distributed by SEI Investments Distribution Company (SIDCO), 1 Freedom Valley Drive, Oaks, PA 19456, which is not affiliated with Krane Funds Advisors, LLC, the Investment Adviser for the Fund. Additional information about SIDCO is available on FINRA’s BrokerCheck.