Boom to Bust: A gloomy future for Chinese tech stocks

• The macro backdrop in China remains delicate amidst weak export and domestic consumption data. Investors banking on a sharp recovery in Chinese growth may end up being disappointed, and this is especially relevant for Chinese tech companies given their cyclical nature. 
• Greater state interference could potentially impair Chinese tech companies’ long-term growth prospects.
• We are wary of any potential fallout from heightened geopolitical tensions. This includes the possibilities of a re-emergence of delisting troubles, as well as potential sanctions.
• Valuations have shot up recently and appear to be overly optimistic, especially given our view that the long-term potential of Chinese tech companies has been impaired.
• Using a fair P/E ratio of 22.5X, we estimate a potential downside of -32% for the iShares Hang Seng Tech ETF (HKEX:3067) by FY24, with a target price of HKD 5.60.

The Hang Seng Tech Index – a key barometer of Chinese tech stocks – started the year with a strong rally. However, this was short-lived with an equally sharp correction following after in Feb 2023, which has since erased its YTD gains and left the index in the red (-4%). More importantly, on a longer time horizon, the index is down a whopping -64% from its peak in Feb 2021, failing to fully recover from the multiple blows inflicted on the Chinese economy and its tech sector since the pandemic (Chart 1).

Given the extent of the Chinese tech beatdown thus far, coupled with fragile macro fundamentals and multiple risks lurking in the backdrop, we think it will be difficult for Chinese tech companies to repeat their strong performance of the previous decade. As such, we recommend investors underweight Chinese tech stocks, and related ETFs like the iShares Hang Seng Tech ETF (HKEX:3067).

Chart 1: Hang Seng Tech has failed to recover from the tech crackdown

A breakdown of the iShares Hang Seng Tech ETF

The iShares Hang Seng Tech ETF is a passive ETF which aims to track the 30 largest stocks on the HKEX, which are either in the tech sector or have tech-enabled businesses. Given the strong emphasis on tech, it is no surprise that it is concentrated in three sectors: Consumer Discretionary (43%), Communications (30%), and IT (26%) (Chart 2). Looking at its top 10 holdings, it is clear that while this is a broad tech ETF, it is nonetheless heavily concentrated in soft-tech segments – this includes media conglomerates like Tencent (8.1%), consumer internet giants like Meituan (7.9%), and entertainment companies like NetEase (5.2%) (Table 1). As such, our analysis below will also put a greater emphasis on the soft-tech aspect.

Chart 2: Hang Seng Tech contains a very large allocation to cyclical sectors

Table 1: ETF is more concentrated in soft-tech segment

Macro outlook remains delicate – markets may be overly optimistic

Chinese exports are witnessing a deceleration in global demand (Chart 3), meaning China will increasingly have to look inwards. However, their domestic market remains fragile. Consumer confidence remains weak based on data from the NBS (Chart 4), and this is also reflected in household savings which have continued to increase despite the recent reopening (Chart 5). These suggest that Chinese consumers remain cautious on the broader macro outlook as well, and could even dampen the effect of any potential stimulus by the government in 2023.

Chinese authorities have recently unveiled a conservative GDP target of 5% for 2023. This 5% figure is one of the lowest targets in history (apart from 2020), and is much lower than the prior growth figures in the pre-COVID era. Newly-appointed Premier Li Qiang himself has also said (after the NPC) that achieving this target will not be easy due to lingering macro risks. Coupled with what we have seen above regarding slowing exports and consumer data, we therefore believe that China’s economic growth will continue to decelerate relative to its pre-COVID trajectory.

In other words, China’s macro outlook remains very delicate in the near term. This does not portend well for Chinese tech equities as this segment contains many cyclical sectors (Chart 2 above), which could be hit harder by any slowdown in Chinese growth.

Chart 3: Chinese exports demand continues to slow

Chart 4: Consumer confidence in China remains low

Chart 5: Chinese consumers continue to put more money into savings

Greater state interference may impair long-term growth prospects

We also believe that China’s move towards greater state control could hurt many of its private enterprises within the Hang Seng Tech Index. The wide-ranging tech crackdown beginning in 2020 has demonstrated that no company in China is “too big to fail” – major tech companies with multiple divisions have even been hit on multiple fronts (e.g. Tencent for anti-trust violations as well as gaming crackdowns) (Table 2).

In the 2010s, many Chinese internet companies went through a period of high growth, helped by their abuse of market power to stifle competition, such as by forcing merchants to choose only one distribution channel (i.e. ‘pick one from two’ or 二选一). However, the Chinese SAMR has since slapped heavy fines on involved tech companies and developed new antitrust guidelines for companies to abide by. We think that these fresh guidelines and regulations are here to stay, and internet companies are unlikely to repeat their massive growth of the 2010s.

In addition, there are multiple signs that Chinese tech companies are not yet out of the woods from a regulatory perspective, and we provide a few notable examples highlighting recent potential state interference within the sector:

1. Authorities acquired “golden shares” in Alibaba and Tencent in Jan 2023, similar to Kuaishou (2022) and Weibo (2021) on previous occasions. This signals the government’s intent to exert more control over these tech companies.
2. The sudden disappearance of Chinese investment banker Bao Fan (founder of China Renaissance) is concerning, considering his history of big-tech deals (including the Meituan-Dianping merger in 2015). His company has since reported he is “cooperating in an investigation” with scant details, echoing Jack Ma’s (Alibaba) disappearance in 2020.
3. Big-tech chiefs like Tencent’s Pony Ma and Baidu’s Robin Li have been excluded from the NPC this year, suggesting they may have already lost significant influence within government inner circles.

Ultimately, we think that increasing government interference in these Chinese tech companies could blur the line between private enterprises and the central government. More importantly, regulatory risks as a whole will continue to bring prolonged uncertainties to the Chinese tech segment for many years to come, with future crackdowns no longer a remote possibility.

Table 2: Examples of industries and companies affected by tech crackdown

Be wary of heightened geopolitical tensions

US-China relations have recently deteriorated, due to multiple events like the spy balloon saga, as well as disagreements over the Russia-Ukraine War. With the normalisation of relations looking extremely unlikely at this point, we think that this could weigh on the long-term prospects of Chinese tech companies in multiple ways.

Delisting troubles are over … but only for now

First, geopolitical tensions could potentially result in a re-flaring of delisting risks, for Chinese companies listed on foreign exchanges (especially in the US). Despite a brief reprieve with the PCAOB announcing it has sufficient access to audit documents for now (Dec 2022), we think there is a concerted push by authorities on both sides for a decoupling of Chinese companies and foreign stock markets. In the US, lawmakers have passed legislation to hasten the delisting process from three to two years. In China, authorities have already voiced concerns about data security risks and begun to encourage state-owned companies to move away from big-four auditors.

Over the longer term, we think that delisting issues could eventually re-emerge if geopolitical relations continue to worsen, resulting in additional volatility for Chinese companies listed on foreign exchanges. This would likely hurt Chinese tech companies, especially as many of them are dual-listed in the US (e.g. Alibaba [HKEX:9988 / NYSE:BABA] and JD.com [HKEX:9618 / NASDAQ:JD]).

Sanctions also pose a significant downside risk

Apart from delisting concerns, we also caution that geopolitical tensions could affect the Chinese tech segment on a more broad-based level, including non-dual-listed companies. Recent examples include Huawei (unlisted) for its close PLA ties, ZTE Corporation (HS Tech constituent in 2021) for violating export regulations, and SMIC (about 4.1% allocation in HS Tech) to slow down the pace of China’s technological advancement. Even more recently, the US has threatened to ban Tiktok (unlisted) over data and privacy concerns.

These policy measures could severely affect the profitability of Chinese tech companies over the long term. For instance, sanctions may already have adversely affected hard-tech companies like SMIC - it has delayed the operation of its new USD 7.6 billion factory due to equipment shortages. The exports ban on advanced chips imposed by the US could also stymie the development of soft-tech companies and their development of advanced software (e.g. AI capabilities like ChatGPT equivalents). It is furthermore increasingly likely that Chinese soft-tech companies will continue to face increasing scrutiny over their handling of data, similar to what Tiktok is currently facing.

These delisting and sanctions risks will be amplified by increasing state participation in private companies (e.g. through golden shares described above), which could prompt further actions by US lawmakers. In short, investors should be mindful of geopolitical tensions between the US and China, and the potential negative effects they could have on the long-term profitability of Chinese companies.

Valuations appear to be pricing in too much optimism

Valuations for the Hang Seng Tech Index, based on forward P/E ratios, have recently shot up (since 4Q22) alongside stock prices amidst optimism over the COVID-19 reopening. Consensus earnings estimates imply a forward P/E of about 35X, similar to its historical average of 35X since Mar 2021 (Chart 6). While this implies that Hang Seng Tech is sitting at “fair” valuations, we think it is pricing in too much optimism. With the long-term growth potential of Chinese tech companies now impaired, we believe that this sector now warrants a lower fair P/E of 22.5X. This is a downgrade from our previous fair P/E of 30X, and is also at the lower end of its historical P/E range, close to lows hit in FY22.

As for earnings, we also believe that markets are overly optimistic. Consensus estimates are implying earnings growth of over +40% each in FY23 and FY24, which could likely be due to analysts extrapolating the strong earnings growth of the 2010s, before COVID and the tech crackdown. Given our belief that new tech regulations are likely to stay, we have instead forecast a much smaller magnitude of positive earnings growth in both years (FY23: +10%, FY24: +5%).

Chart 6: HS Tech implied valuations are currently near historical averages

Continue to underweight Chinese tech companies

Using a fair P/E ratio of 22.5X, we estimate a potential downside of -32% for the iShares Hang Seng Tech ETF (HKEX:3067) by FY24, and we believe that prices have run far ahead of fundamentals (Chart 7, Table 3).

We recommend underweighting Chinese tech companies, not only due to the delicate macro outlook there, but also in light of heightened risks from state intervention and geopolitical events. While prices have already fallen from their peak this year, we caution that there could be more declines, especially when markets realise that the long-term potential of these Chinese tech companies has been impaired.

Chart 7: HS Tech Index Price Performance and EPS

Table 3: iShares Hang Seng Tech ETF Projections 2023 - 2024