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16 Jan 2024

Tech Titans In Focus: Contrasting The US And Chinese Tech Markets

The US technology sector was on a tear last year. It dramatically outperformed the tech sectors of other markets, including the world’s second biggest tech market, China. In this article, Foord Global Equity Fund portfolio managers Brian Arcese, Ishreth Hassen and JC Xue examine the underlying drivers of the US and Chinese tech sectors and their respective investment potential.

Despite similar growth rates of the constituent companies, the share market performance gap between US and Chinese tech firms is significant. The US tech giants known as The Magnificent Seven (see Did you Know?) collectively returned 111% in 2023 on an equal-weighted basis (yes, they doubled). Together, they accounted for about 60% of the S&P 500's return last year. In contrast, the Chinese tech sector lagged in 2023, falling 8%. This disparity was a headwind to the fund’s performance and invites a deeper exploration of the factors at play.

In parallel to their US counterparts, Chinese tech companies enjoy similar secular growth trends. For example, Tencent aligns with Facebook in digital advertising growth, JD and Alibaba with Amazon in e-commerce growth, and Baidu with Google and Nvidia in AI proliferation. However, a key distinction is that whereas US tech companies are truly global, Chinese tech companies are predominantly domestically focused.

This domestic orientation makes sense with a largely homogenous population of 1.4 billion Chinese speakers. However, it makes Chinese tech firms more susceptible to China's macroeconomic conditions and erratic regulatory oversight. These factors are the main reasons for the underperformance of the Chinese tech sector. The government crackdown on tech platforms has not only slowed growth rates, but also dampened investor sentiment towards these companies.

Conversely, US tech giants have achieved phenomenal earnings and share-price growth due to their monopolistic presence, global product scalability and the market’s unbridled optimism for indefinite growth. The result is that the sector is trading at its highest valuation outside of the 2000 tech bubble — with some companies priced for perfection.

The main investment risk with US tech is whether the sector is overvalued relative to its future growth potential, with prospects of poor investment returns from these stratospheric levels. Tesla is a good example. The stock trades at a price-to-earnings (P/E) ratio of 80 times its consensus earnings for 2023. In layman’s terms, this means that it will take 80 years of current earnings to recoup the purchase cost if you buy the stock today.

The Tesla valuation is high because the market is pricing in dramatic growth in the company’s future earnings. However, even if Tesla grows its earnings by 20% per annum for the next five years, the stock will still trade on a P/E ratio of 32 times by 2028. That 32-times P/E ratio would be nearly double the US market’s long-term average. We regard even that PE ratio as too expensive for a cyclical automotive business with software optionality.

In contrast, the Chinese tech sector is seen by some investors to be a value trap: despite strong free-cash flows and seemingly attractive valuations, Chinese tech stocks have struggled to gain momentum. Their future performance hinges on the recovery of China's economy — currently mired in a prolonged slowdown — and regulatory restraint.

Until late last year, the Chinese regulatory environment was showing signs of again becoming more supportive after several years of restriction. Developments such as the approval of new games and encouraging government interactions with tech platforms suggested a positive shift. However, tough draft online gaming regulations released in December rocked the gaming sector as well as investor confidence. Regulators quickly u-turned by softening their position after the gaming sector rout. Ongoing US efforts to limit semiconductor access for Chinese tech firms also remains a significant geopolitical challenge.

Regulatory pressures will also shape the prospects of tech firms in other markets. US tech firms face increasing antitrust scrutiny in the US and EU. Aside from ‘old’ regulations, such as those for cybersecurity and data protection, tech platforms will encounter new regulations in the novel area of artificial intelligence and machine learning. The New York Times has already filed a copyright infringement lawsuit against Microsoft and ChatGPT owner OpenAI for the ‘billions of dollars in statutory and actual damages’ it claims it is due for the unlawful copying of proprietary content.

When it comes to evaluating technology companies for investment — whether in the US or China — Foord’s approach remains consistent. We focus on the sustainability of key competitive advantages, the growth runway, management quality and (of course) valuation. However, there are market nuances to consider. For example, Chinese consumers are more averse to paying for software, given the greater levels of software piracy there. There is also a greater competitive intensity in China, which means that Chinese tech companies are more likely to diversify into other tech areas — bringing both opportunities and risk. This necessitates a more nuanced approach in valuation and risk assessment.

The decision to invest in US or Chinese tech is not binary. We can — and do — own leading tech names in both markets as well as some European domiciled names. Our weightings are guided by valuations of the stocks that we like and therefore the risk/return prospects for our investors. Accordingly, the portfolio management focus is not on specific geographies, but rather on the value these sectors offer.

While revenue growth has slowed for the Chinese tech stocks that we own in the Foord Global Equity Fund, their earnings have continued to compound as we anticipated — making them even cheaper than when we first started building our positions, and further increasing the value disparity against US tech. For example, Alibaba, Tencent and JD.com earnings have all grown more than 50% since 2019, yet the stocks have continued to derate due to broader macro and — in our view probably unfounded — geopolitical sentiment.

The investor Howard Marks famously said that ‘Trees don't grow to the sky, and few things go to zero. Rather, most phenomena turn out to be cyclical.’ We believe this applies to the US-China tech sector disparity also. We don’t expect US tech stocks to soar ever higher. We hold the better valued and better quality US tech stocks in our portfolios. We do, however, expect that the anti-China sentiment will reverse in due course and, that when it does, positions which have been a headwind to portfolio performance will become a tailwind.

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