Seeking Alpha

Buy Alibaba And Tencent Amidst Rout In Chinese ADRs

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Includes: BABA, CQQQ, JD, TCEHY, TCTZF
by: Greenwood Investments
Summary

Chinese ADRs were hit hardest as it was reported on Friday that the US was weighing the possibility of curbing US investments in China.

Out of the Big 4 in Chinese Tech, my top picks are Alibaba and Tencent for their unrivaled dominance in the fields they are involved in.

I believe Trump will favour a trade deal prior to his election next year. If a deal comes to fruition in October, the damage to Chinese ADRs will be undone.

It feels like the Trump administration spends an inordinate amount of time conjuring up new ways to penalize China. In yet another show of one-upmanship, it was reported late on Friday that the US was weighing the possibility of curbing US investments in China. This may include de-listing Chinese companies from US exchanges, and preventing US government pension funds from investing in the Chinese market. As of now, no concrete details have been floated.

The news development comes just before the next round of US-China trade talks planned on October 10. In all probability, the US administration could be raising the stakes to give their negotiators a stronger chance of extracting more favourable terms from China. The timing of the news also coincides with China's grand Golden Week national holiday that begins on October 1, which could be designed to rattle Liu He's negotiating team just a little more to give the US an extra edge.

Chinese ADRs naturally took the brunt of the beating, with the Big 4 of Chinese Tech companies closing between 3-5% lower on the day. Alibaba Group (BABA) plunged 5%, JD.com (JD) fell 5%, Baidu (BIDU) retreated by 4%, and Tencent (OTCPK:TCEHY) (OTCPK:TCTZF) dropped 3%.

I have written in detail on the recovery of the Chinese Technology sector since August 2019, as materialized by the 7% gain in the Invesco China Technology ETF (CQQQ) since my article. Below, I review the Chinese Technology sector again, and look at my top two picks out of the Big 4 of Chinese Tech.

Invesco China Technology ETF Weekly Chart

Since August, CQQQ has formed a W-shaped bottom near major supports around $40. For the ETF to really break out higher, it needs to bust through the $52 neckline resistance. CQQQ dropped about 2.7% on Friday, but did the sell-off cause any technical damage? No, not yet at least. The W-shaped bottom has not been invalidated, and we have seen weekly sell-offs of similar or larger magnitudes in the past too - just look at the size of previous weekly candlesticks. As such, I am still of the belief that CQQQ will trend higher.

I am also of the belief that this news development could be a bargaining chip used by the Trump administration to tilt October's negotiations to their favour, with Trump likely favouring a deal before his presidential election next year. If a trade deal comes to fruition, the damage to Chinese ADRs will be undone.

Within China's Tech Big 4, I like Alibaba and Tencent for their unrivaled dominance in what they do.

Alibaba

Alibaba is the most dominant e-commerce retailer in the world's most populous country, accounting for a massive 58% of market share in China. JD.com lags behind in a distant second with 16% of market share, which is why I favour BABA over JD. China's enormous market of 1.4 billion people, combined with a steadily growing middle class and high e-commerce penetration rate, makes BABA a great cornerstone addition to your portfolio for the next 3-5 years at least.

According to emarketer, China is set to displace the US this year as the world's top retail market, with China's total retail sales pie standing at $5.6 trillion. E-commerce is a major driver of retail sales in China, accounting for 35% of total retail sales. This percentage is the highest in the world, and at the same time, there is still much more room for e-commerce sales to grow. If so, BABA will be one of the main beneficiaries. Comparatively, e-commerce sales makes up only 10% of total retail sales in the US.

Importantly, BABA has another key growth driver in its arsenal: cloud computing. According to Nikkei Asian Review, China is the world's second-largest public cloud market after the US, with spending estimated to reach $10.5 billion this year. In China, BABA has a market share of 43%, with Tencent behind at 11.5%. BABA also leads the Asia Pacific cloud computing market with close to a 20% market share in 2018.

While the cloud computing segment makes up only about 7% of BABA's total sales currently, this is a high-growth area for the company as seen from its 61% YoY sales growth reported during the June quarter. Jack Ma famously said that the cloud was a future lifesaver for BABA, saying "If we don't do this, we will die."

Alibaba Group Weekly Chart

The technical chart for BABA looks compelling. The stock formed two sets of W-shaped bottoms in 2019, which tells me that the stock is seeing incremental buying, especially between the $130-$150 area. BABA needs to break above the $195-$200 neckline to complete this bullish reversal pattern. While last week's sell-off was damaging, there was no lasting technical damage to the stock. I believe BABA is still on an uptrend, and a break of the $195-$200 neckline will add rocket fuel to its rally.

Tencent

Tencent's decline on Friday night was probably the least justified, given that the stock is not even listed in the US. Heck, Tencent does not even depend on overseas sales for its revenue, with almost 100% of its sales coming from Mainland China. Unfortunately, Tencent was dragged down along with the rest of its peers.

Tencent has many very profitable avenues of growth. It owns the most popular social media messaging app in China, WeChat, which has 1.1 billion monthly active users in Q2'2019, according to Statista. This is potentially an advertising goldmine for Tencent, but only 18% of the company's revenues are derived from online advertising. In the near term, a slowing Chinese economy may impact advertising revenue for Tencent, as seen from a deterioration in WeChat advertising in its Q2'19 results. In the longer term however, advertising can be a strong lever of growth if Tencent manages to monetize WeChat effectively.

Tencent's core business is still gaming, making up slightly less than half of its total sales. The company's revenues were impacted by a months-long freeze in new games approval by the Chinese government in 2018, but that is now water under the bridge as games approvals have resumed again. This change in fortunes were reflected as Tencent reported a 35% rise in profit in 2Q'19 driven largely by better-than-expected gaming revenue.

Tencent is the world's largest gaming company, owning Riot Games (creator of "League of Legends"), a 40% stake in Epic Games (creator of "Fortnite"), and a majority stake in Supercell (creator of "Clash of Clans," "Clash Royale"). On top of that, the company has small stakes in Activision Blizzard (ATVI) and Ubisoft (OTCPK:UBSFY). To enter the Chinese market, international games developers need a Chinese partner, which has more often than not been Tencent.

Tencent Weekly Chart

The technical chart for Tencent looks less compelling than BABA's. While the stock is still on an uptrend, recent price weakness makes it possible that Tencent will trade lower to retest its uptrend support. A buy entry would be more attractive form a risk-reward perspective if prices for TCEHY were closer to the $36 level.

Duopoly in China e-payments market

Tencent's dominance in social media has naturally given it a strong foothold in the lucrative e-payments market in China, estimated to be worth $4.7 trillion, via the company's WeChat Pay platform, which has an estimated market share of 38.9%. BABA's Alipay is still the undisputed leader, with 53.8% market share. This means that both BABA and Tencent own a combined 92.7% market share of the China e-payments market.

Dominance in China's tech start-up scene

Most promising tech start-ups in China receive funding from either BABA, Tencent or Baidu. According to The Economist, these three account for investments in about 50% of "unicorns" - valued at $1bn or more. By the time these startups hit a valuation exceeding $5bn, 80% would have received some sort of investment from one of the three big boys.

This has led to BABA and Tencent holding a portfolio of Chinese unicorns spread out across a myriad of industries. If you are of the belief that China will likely stand toe-to-toe with the US in terms of technological advancement within the next decade, then investing in BABA or Tencent means you are buying a stake in this future.

This chart below sums up BABA's and Tencent's dominance across various technological sectors in China. You can see that with the exception of Search, both BABA and Tencent have dominant positions in almost every other field across online entertainment, social media, advertising, B2B, mobile payments, etc. The list goes on, and will be expected to grow longer due to their investments in the future of Tech via young start-ups.

The trade war has created sell-offs in Chinese Tech, and opened up opportunities for investors to buy into attractive, solid names. Both Alibaba and Tencent stand out due to their complete dominance in the fields they are involved in. They are extremely entrenched and invested in the Tech start-up scene in China, and hence buying into them would be akin to buying a slice of the future of Tech in China. Both stocks should be main cornerstones in an investor's portfolio, if they aren't already.

If I had to choose one out of the two, I would lean towards the former a little more as I see e-commerce as a stronger growth story than the games market. More crucially, Alibaba's technical chart is more compelling than Tencent's, as it is indicating incremental buying near current price levels. While more long-term investors can consider adding both stocks to their portfolios to buy a more holistic stake in China's Tech future, I would prefer to wait on the sidelines for Tencent until the charts turn more constructive.

This is a snapshot of past trading calls for The Naked Charts since June.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.