Best ADR Stocks: Alibaba

Summary

• The Power Factors System is a quantitative stock-picking system that has produced outstanding returns in the long term.
• Applying the system to a universe of ADRs generates an impressive annual return of over 18% per year since 1999.
• Among the ADRs currently selected by the system, Alibaba looks like a particularly interesting candidate to consider.

There is no magic and infallible formula to picking winning stocks, and even the best quantitative systems can go through periods of underperformance from time to time. That being said, The Power Factor System works quite well across different universes over long periods of time.

The system basically ranks companies in a particular universe based on three effective and time-proven return drivers: financial quality, stock valuation, and business momentum. We are basically looking for companies generating sound profitability, stocks trading at reasonable valuation levels, and businesses that are doing better than expected.

The concept is quite simple and easy to understand, but that doesn't make it any less effective. On the contrary, backtested data shows that applying the Power Factors System to different sectors and markets tends to consistently deliver above-average returns.

The following backest applies the Power Factors System to a broad universe of over 1,000 ADRs listed in U.S. exchanges. The portfolio picks the best 50 names according to the ranking system, and then it builds an equally weighted and monthly rebalanced portfolio with those stocks.

The Power Factors portfolio is assumed to have an annual expense of 1% to account for trading expenses and slippage, and the benchmark is the Vanguard Total Stock Market ETF (VTI).

Backtested performance is nothing short of extraordinary. The Power Factors system produced an average annual return of 18.49% since January of 1999, while the Vanguard Total Stock Market ETF gained a much smaller 6.67%. Alpha for the quantitative system is an impressive 12.14%, and the Sharpe Ratio stands at 0.84 versus 0.37 for the benchmark.

Putting the numbers in perspective, this means that a $100,000 investment in the Vanguard Total Market ETF in January 1999 would currently be worth around $336,900. In stark contrast, the same amount of capital allocated to the portfolio recommended by the Power Factors System would have a much bigger value of over $2.4 million.

Data and charts are from Portfolio123, and the complete portfolio of companies currently selected by the system is available to subscribers in The Data Driven Investor.

Case Study Alibaba

Alibaba (NYSE:BABA) doesn’t leave much to be desired in terms of financial performance or business momentum. The company produced $8.29 billion in revenue during the quarter ended in September, growing by 60.7% year over year and beating Wall Street estimates by $440 million. This kind of growth is quite exceptional, especially coming from one of the biggest corporations in the world.

Alibaba’s multiple business segments are firing on all cylinders, which is a major positive when evaluating the company's ability to sustain performance going forward. Core commerce revenue grew 63%, cloud computing revenue increased 99%, digital media and entertainment grew 33%, and innovation initiatives and others increased 27%.

Source: Alibaba

Even if Alibaba is investing massive amounts of money in all kinds of growth projects, profit margins remain attractively high. Operating margin measured in RMB amounted to 30% of revenue last quarter, while adjusted EBITDA margin stands at nearly 42% of sales.

All being said and done, Alibaba reported $1.29 in adjusted earnings per share last quarter, growing by a vigorous 63% year over year and beating estimates by $0.26 per share.

Valuation is a very different story, though. This kind of growth seldom comes for a cheap price, and Alibaba’s valuation ratios are substantially above average.

Wall Street analysts are on average expecting Alibaba to make $6.54 in earnings per share next year, meaning fiscal year 2019 for the company. Under this assumption, Alibaba is trading at a relatively expensive forward P/E ratio in the neighborhood of 28. The average forward P/E ratio for companies in the S&P 500 is in the area of 21, so Alibaba stock is clearly priced at a premium versus the average stock in the market.

On the other hand, the company is far superior to the average stock in terms of variables such as growth, profitability, and financial momentum. It’s important to note that successful players in the online commerce industry tend to trade at even higher valuation levels. Names such as Amazon (AMZN) and MercadoLibre (MELI) trade at forward P/E ratios of 135 and 58 times expected earnings, respectively.

This example shows why a quantitative ranking system that incorporates multiple factors in combination can be a smarter approach than a stock screener that simply filters stocks based on absolute values for different parameters.

If you look at valuation ratios in isolation, Alibaba stock can seem overpriced. However, when analyzing those ratios in the context of the company’s overall fundamental performance, things look much different.

It’s also important to analyze the business behind the numbers from a qualitative point of view in order to tell if those numbers are sustainable or not. Aspects such as competitive strengths and future growth opportunities are crucial considerations in this area.

Alibaba is the leading player in the Chinese e-commerce industry thanks to its massive scale and brand recognition. The company has more than 488 million annual active customers, meaning users that make at least one purchase per year in Alibaba’s China online marketplaces. Mobile monthly users, meaning unique users who access the company’s mobile applications amount to 549 million as of the most recent earnings report.

Source: Alibaba

The business model is a textbook example of a company benefiting from the network effect. This means that the value of the service increases as the company gains size over time. Buyers and sellers attract each other to the most popular e-commerce platforms, and the same goes for the company’s digital payments system: Alipay.

A bigger Alibaba provides a more valuable service to customers and users in different business segments, creating a self-sustaining virtuous cycle of growth and increasing competitive strength for the company.

According to management estimates, the retail sector in China generates nearly $5 trillion in annual revenue, and only 15% of those transactions are currently happening online. As the lines between online and offline retail are increasingly disappearing, this should generate extraordinary growth opportunities for Alibaba over the years ahead.

Alibaba’s financial performance numbers are exceptional, and the company has both the competitive strengths and the growth opportunities to sustain such performance going forward. This should drive attractive returns for investors in Alibaba stock.

Analyst’s Disclosure: I am/we are long BABA, AMZN, MELI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.