China turmoil creates opportunity

While the Nasdaq continues to climb to record highs, it could not be more different for the Chinese equivalent, with the China internet index halving from its peak in just six months and approaching the lows reached at the depths of the Covid-19 market meltdown. Ever since Chinese regulators halted the listing of the highly anticipated Ant IPO late last year, a series of bad news continues to plague the sector, and brought 'China risk' to the forefront. The disappearance (and reappearance) of Alibaba founder Jack Ma, banning ride-hailing giant Didi from app stores, overhaul of the for-profit education sector, dictating minimum wage guidelines for delivery drivers - something new seems to be revealed which each passing day and is spreading beyond the tech sector.

The question becomes, why is the Chinese Communist Party doing this? There are many theories for this. Whether it be the Government reining in monopolistic practices, tightening its grip on power, preventing foreign investors from profiting off China's rapid growth, intervening for the sake of the greater good of China and its people, the list goes on. The reality is though, that nobody knows.

China's largest company, Tencent has been caught in the maelstrom. After being on the cusp of reaching the rare trillion dollar club earlier in the year, it now sits at $550bn. The internet giant is a leader in multiple fields including gaming, digital advertising, media subscriptions and operates the ubiquitous Wechat app, a platform for messaging, social networking and mobile payments. With over a billion users across its platforms and the average user spending ~1hr on Wechat, it is hard to overstate the importance of Tencent in modern day living in China. Imagine a company that collectively housed all these businesses: Whatsapp, Facebook, Visa, Mastercard, Paypal, Nintendo, Activision Blizzard, EA Sports, Netflix - that's Tencent. But wait, there's more. Tencent also has a vast investment portfolio of over a hundred hundreds listed and unlisted companies which we conservatively estimate at $250bn. These investments include some of the most promising companies in the world including Epic (behind hit-game Fortnite), Tesla, Sea and Afterpay. In the last five years, this portfolio has grown ~10x, which is all but certain to be one of the best investment records in the world.

The last time Tencent suffered a substantial drawdown was in 2018 when it also halved in value. Back then, it was trade war tensions between China and USA combined with a clampdown on games approvals by regulators due to concern of violent content in games and the impact on children's eyesight from playing games. Games were not being approved and some titles were banned which led to Tencent's first quarterly profit decline in over a decade. By the end of 2018 however, regulators began approvals again. Since then, Tencent has made changes to limit users in-game play time and spending.

If we look at valuation, Tencent trades at 25x PE, the cheapest it has been since 2013. However, if we net out its vast investment portfolio, its trading at 13x PE. That's for a dominant cash cow business at the centre of multiple secular megatrends and with a rapidly appreciating investment portfolio. These metrics have little meaning if the Government chooses to implement drastic changes, however we believe Tencent's vast userbase and resources will allow it to adapt to alternative monetisation models. We have no idea what actions the Government may or may not take on Tencent, but at current levels, barring an outright worst case scenario, we think the risk reward is strongly skewed to the upside.