Investing in tech stocks: A risk and reward analysis


Over the last few months, the Chinese government unleashed a deluge of tightening measures on various industries. From imposing the “three red lines” on the property sector, reining in internet companies over data security issues, to banning for-profit tutoring in core school subjects, the rationales behind their introduction vary. In today’s article, we will be focusing primarily on the policies’ impact on Chinese technology stocks.

Before we delve into how the measures hit these companies, let’s take a step back and tease out the logic on which they are built. Judging from multiple sources, we think it comes down to three main reasons. First, to prevent leakage of confidential national data and state secrets, and to protect national security. Second, to prevent monopoly and encourage competition. Third, to prevent large corporates from exploiting employees. To the entire tech industry, the changes these reasons will potentially set off will be tremendous.

Jack Ma once said that, data is to the modern world what oil was in the previous century. User data allows companies a glimpse into users’ preferences and habits, enabling them to recommend services and products more accurately suited for target customers. Naturally, the critical role data plays becomes increasingly clear to China. But the question is: how will the country stop the data from leaking abroad and putting national security at risk?

On June 10 this year, China passed a new data security law, yet concrete details in implementing it are still unclear[1]. What we can infer from Didi Chuxing’s debacle in its attempt to go public in the US is that, China will likely take a cautious stance towards foreign investments in domestic internet companies and hence curb the willingness of those foreign funds to put money into China’s internet sector. The law also poses a hurdle to venture capital funds wishing to exit existing investments through IPOs. But on the flip side, weaker investment inflows also translate to better access to potentially attractive start-ups for existing investors.

Moreover, the monopoly power once in the firm grip of large tech groups will perhaps come to an end. While internet behemoths have had an enormous advantage over small companies in data, recent developments will likely turn the table around. Discussions have also emerged over whether the state will step in to take over these data. Provided that sharing the data will not put national security in jeopardy, with a small fee, small companies and non-tech companies may also be allowed access to a wealth of data previously only available to large technology companies. But the idea of data being a gold mine is premised on a thorough understanding of its nature and the ability to conduct analysis with it, so a mere broadened access has no bearing on whether every company will be able to benefit from it.

Another point worth noting is that China’s internet industry is primarily dominated by two local giants, with their respective payment systems all but incompatible with each other’s ecosystem. But this will likely change as an increase in competition will put a dent in the profitability of their payment businesses.

Finally, what would result from the measures aimed at stopping large companies from exploiting their employees? Most delivery workers or taxi drivers relying on existing gig economy platforms for income are independent contractors, meaning that they are not employed by these companies, which under such arrangement have no obligation to bear the workers’ social security expenses. However, if relevant laws are revamped to require these platforms to do so, the total annual expenditure on social benefits will cost the largest food delivery company China as much as RMB40 billion according to an estimate by a local media outlet[2]. While this may be a rough estimate, it sheds light on how big of a shakeup it could bring about.

But this is not to say that these factors will strip tech stocks of all investment value. While technology companies may see a decline in their data advantage, they can still count on the benefits of economies of scale and networking effects. Having said that, the days where their valuations stood at elevated levels may have been gone.


[1] Source: The National People’s Congress of the People’s Republic of China, as of June 2021

[2] Source: Sina Finance, as of July 2021


Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

The opportunity cost of reinvestments – is it worth it?


Shortly after Didi Chuxing’s US IPO, the ride hailing company saw its mobile app banned from app stores by Chinese regulators. And as of late August, it witnessed its share price plunge by over 50% from a previous high[1]. But it is not our intention to chip in on any network data security issues, as existing articles have sufficiently covered that ground. Instead, we seek to understand whether tech companies should sacrifice short-term profits in favour of aggressive business expansion.

It’s key to talk about why such questions merit further analysis. In the past, under the traditional economy, professional investors often shunned companies that weren’t profitable. But we see the opposite takes place in today’s new economy: companies such as Amazon and Tesla, i.e. those that are still in their investment phase and yet to be profitable, are clearly the frontrunners in terms of global market value.

The concept of profits no longer seems relevant, as many new tech companies invariably decide to pump capital into developing new businesses as well as research and development. The redder a company’s balance sheet, the higher its stock price. Apparently, such is the trademark of a new trend.

It resembles Didi’s business development strategy. According to its IPO prospectus, Didi’s domestic ride-hailing business began turning profits in 2019, with moderate year-on-year growth in 2020 despite the pandemic’s blow[2]. Meanwhile, the company continued to plough money into new businesses and new technology research, which resulted in Didi making losses as a whole for the past three years2.

Didi’s new business ventures and R&D efforts covered a diverse variety of projects. In its foray into new business lines, the ride-hailing company has launched operations in overseas markets and began offering food delivery services. In China, Didi started providing bicycle and electric bicycle rental services in 2018, and rolled out a domestic logistics freight unit and a group-buying arm in June last year. Meanwhile, the tech conglomerate has ventured into financial services, and has been focusing its research firepower in the development of electric vehicles and autonomous driving systems.

But to understand whether persistent reinvestment in a loss-making company should be considered a positive trait, we think it’s key for investors to differentiate the nature of investment projects in the old and new economy, and how investments are treated differently by accounting standards. In the past, investments could mean production plants and machinery, which were all tangible. Their values might change over time, but they didn’t tend to change abruptly, and were more transparent as these assets were bought and sold in the second-hand market. Accounting standards therefore treated such items as investments, instead of costs.

But in today’s new economy, with most investments being intangible assets – ranging from software, or new medical or engineering patent rights – it can be difficult to pinpoint exactly how much these assets are worth, or to buy and sell them in any market. Accountants, erring on the side of caution, would usually treat these expenses as costs and deduct them from profits. But if we think about it, a successful software or patent can command much higher value than tangible assets, even though they aren’t treated as investment items like factory buildings and machinery. Instead, they are considered as expenses, which ultimately have an impact on a company’s profit margins in the balance sheet.

But of course, not every investment will turn out to be a success. Indeed most of the research expenditures should probably be treated as part of the costs. So the question as to which ones are successful and which aren’t, will ultimately rest on each investor’s individual insights and experiences. If an investor is of the view that a given investment or R&D efforts would work in favour of the target company, he/she should consider these expenditures as investments rather than costs.

In our experience, several factors can be used to gauge how successful an investment is. First, is the company in question a pioneer in the industry it’s operating in? It usually points to relatively little competition, meaning that there’s a higher chance of it succeeding in said industry. Second, how big is the industry the target company is operating in? The larger the industry, the easier it is for the company to take advantage of economies of scale. The internet has a global reach, which enables leading companies, such as Facebook and Netflix, for example, to tap on not only the domestic market, but also international consumers. Finally, investors should be convinced of the target company’s ambition to grow, the ability of those at the management level to execute business strategies, and its approach to attracting talents – only companies with these qualities will be well placed to act on the opportunities arising out of the first two scenarios.


[1] Source: Sina Finance, as of Aug 2021

[2] Source: Didi Prospectus, as of June 2021


Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.