Contrarian Play: Buying China Internet ETF KWEB In Times Of Coronavirus Panic

Summary

• The idea of buying KraneShares CSI China Internet ETF in the current market environment can seem crazy to many investors.
• However, the most profitable ideas usually seem crazy in the short term.
• KraneShares CSI China Internet ETF is home to many high-growth companies with enormous potential in the years ahead.
• The timing looks good, as the COVID-19 situation in China is improving, and the momentum indicators look bullish.
• In the short term, it's hard to know how KraneShares CSI China Internet ETF will perform, but over the next few years, chances are that the current price will look like a huge opportunity in retrospect.
• I do much more than just articles at The Data Driven Investor: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

China is the epicenter of the global COVID-19 crisis, and this will have some material implications on the Chinese economy. However, the stock market is a forward-looking mechanism, and investment decisions should be made by looking at the windshield as opposed to the rearview mirror.

KraneShares CSI China Internet ETF (NYSEARCA:KWEB) is home to a collection of high-quality companies with exceptional potential for growth in the long term. Besides, the timing is starting to look increasingly attractive for a position in China Internet stocks.

The Fundamentals

Investing in China carries all kinds of risks and uncertainties related to the political and regulatory landscape, as well as the macroeconomic and cyclicality factors that cannot be disregarded, especially in current times.

However, portfolio risk is not only what you buy, but how much you buy can be even more important. Besides, international diversification is a major consideration to keep in mind when managing risk at the whole portfolio level. For investors with lots of exposure to U.S. stocks, adding some international presence can be a good idea in order to avoid putting all your eggs in one basket.

Many of the most promising investment opportunities can be found in China nowadays, and especially in the Chinese Internet sector, where many businesses are benefiting from enormous opportunities in areas such as online commerce, digital entertainment, social media, digital payments, and all kinds of Artificial Intelligence applications.

In the words of Charlie Munger himself:

"The strongest companies in the world are not in America. I think Chinese companies are stronger than ours and are growing faster."

Internet penetration in China is currently only 60% of the population, but the size of the Chinese population is so big that there are almost 3 times the number of internet users in China as in the United States.

Source: Abacus China Internet Report

China is making massive investments to accelerate the expansion of 5G technologies in the near term, and the country is expected to reach 460 million 5G connections by 2025. This will be a game-changer in terms of connectivity, and it will create all kinds of opportunities for companies in the sector.

Source: Abacus China Internet Report

Even in the short term, Internet companies in China have massive untapped potential for expansion in third-tier cities. It's estimated that there are 128 million Internet users in those markets who have not yet made any purchases online. As disposable income increases and those consumers get increasingly familiar with online purchases, these markets are looking remarkably attractive for companies in the sector.

Source: Abacus China Internet Report

The long-term fundamentals remain strong, but China has faced plenty of challenges in recent years, including decelerating economic growth, the trade war with the United States, and the COVID-19 coronavirus expansion.

In spite of these factors, we can clearly observe how an industry bellwether such as Alibaba (BABA), which is the largest position in KraneShares CSI China Internet ETF, has still managed to deliver sustained growth in revenue, cash flows, and earnings per share.

Data by YCharts

But market sentiment still has big implications in terms of valuation, and Alibaba is trading at historically low valuation levels when looking at price to sales, price free cash flow, and EV to EBITDA ratios.

Data by YCharts

The main point is that the China Internet sector offers enormous opportunities for growth, and valuations are currently quite attractive because of the many uncertainties affecting China in recent years. Short-term uncertainty usually creates opportunities for long-term investors, and this seems to be the case for KraneShares CSI China Internet ETF right now.

The Timing Is Looking Good

If we compare KraneShares CSI China Internet ETF with First Trust DJ Internet Index ETF (FDN), it's easy to see that internet companies in the U.S. have widely outperformed their China counterparts over the past several years.

Data by YCharts

However, the tables have turned recently, and China Internet stocks are doing much better than their U.S. peers in the short term.

Data by YCharts

This may sound counterintuitive in times when global stock markets are under a lot of pressure because of fears about COVID-19 and its implications for the economy. How can it be possible that Internet stocks in China - the epicenter of COVID-19 - are performing better than internet stocks in the U.S?

It's actually very simple. The statistics in China are showing that the number of new cases is clearly declining over the past several weeks, while in the United States, it's still too early to tell how far the situation will go and what kind of impact it will have.

We could always have a new expansion in China, which would obviously be quite problematic. But, right now, it looks like the worst is in the past for China.

Source: Wikipedia with data from China National Health Commission

In order to assess the timing for an entry in KraneShares CSI China Internet ETF, we can take look at the instrument through the ETF Timing algorithm. This is a quantitative ranking system that considers different momentum and trend metrics to rank ETFs based on their price behavior. The table below shows the different factors considered in the algorithm and their respective weights.

Factor	Weight
Return over the past 3 months	30%
3 Months return 3 months ago	20%
3 Months return 6 months ago	10%
3 Months return 9 months ago	10%
1 Month return	-20%
Distance from 200 days moving average	10%

Click to enlarge

The algorithm looks for ETFs that are delivering consistently high momentum metrics across different time frames, but it gives a negative weight to one-month momentum.

The main idea is looking for ETFs that are consistently delivering strong returns in the middle term, not only in the past 12 months in aggregate but also when measuring returns over different sub-periods. However, we don't want the ETF to be too overextended in the short term, so the algorithm gives a -20% weight to the one-month return.

The chart below shows the historical returns for ETFs in different ranking segments versus the 60/40 benchmark. ETFs with a high ranking tend to significantly outperform the benchmark, and there is a direct relationship between the ETF Timing ranking and performance.

Data from S&P Global via Portfolio123

Making decisions based on momentum can produce some very attractive returns, and there's solid academic research proving that momentum works well over the long term. However, assets exhibiting high momentum are many times the ones that also exhibit higher volatility, and this can be particularly concerning in a tough market environment.

If we are facing a market correction in the midst of a long-term bull market, chances are that KraneShares CSI China Internet ETF will deliver above-average returns during the recovery.

However, if global stock markets are entering a long-lasting decline and a new bear market, then KraneShares CSI China Internet ETF will most probably underperform, since high-risk assets lead to the downside in bear markets. In other words, momentum cuts both ways. That's just the way the nature of momentum investing.

That being acknowledged, KraneShares CSI China Internet ETF has a timing ranking of 95, meaning that the ETF is in the top 5% of all ETFs listed in the U.S. when considering momentum over different periods.

If you are looking for an ETF delivering solid performance in the middle term, but not too overbought in the short term, the price action in KraneShares CSI China Internet ETF fits that description quite well.

A Reminder On The Risks

Investing in KraneShares CSI China Internet ETF carries some fairly substantial risks. A particularly relevant concern in the short term is that we could see a new surge in COVID-19 cases in China.

If the authorities are too focused on bringing the workers back to the factories in order to jumpstart the economy as quickly as possible, then this could backfire and create all kinds of problems for the economy in general and for technology companies, in particular.

The fact that China is not a free market country always creates some doubt among analysts regarding the veracity of the data coming from China. Besides, legal and regulatory risks are always hard to quantify.

The government in China recently made big regulatory changes in industries such as online video games and online education, and these changes had big repercussions for players in those areas.

Online companies have crucial information about their users, and artificial intelligence applications in areas such as security can be considered of strategic importance for the government. This means that you never know what kind of formal or informal influence the government in China can have on these companies.

The trade war between China and the U.S. has reportedly entered an impasse until after the U.S. elections. However, we cannot rule out new problems between the two countries, and if this happens, it will most probably have a negative impact on all assets related to China.

Focus On The Big Picture

In can be difficult to consider buying stocks in times when markets are falling non-stop and volatility is at stratospheric levels in the midst of the COVID-19 panic. And if we are talking about buying high-growth stocks in China, the idea can even seem preposterous to some investors.

However, there's no reason to expect successful investing to be easy and comfortable. In fact, the most profitable investment ideas over the long term are often the ones that also seem painful at the time.

KraneShares CSI China Internet ETF is offering exposure to a basket of high-growth companies with abundant potential for expansion in the years ahead, and the one-two punch delivered by the trade war first and the coronavirus panic later could be creating a window of opportunity to invest in China Internet stocks while they are still cheap and starting to outperform.

It's hard to tell how a position in KraneShares CSI China Internet ETF will evolve over the next month. However, when looking at the next year, chances are that the ETF will deliver solid returns as COVID-19 fears dissipate. Even better, over three to five years, there's an elevated probability that investors who purchase KraneShares CSI China Internet ETF today will be quite pleased with the returns.

Analyst’s Disclosure: I am/we are long BABA. KWEB. 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.

I replicate the Data Driven Portfolio with my personal money.