KWEB: China’s Premium Internet Companies Come At A Price

KraneShares CSI China Internet ETF (NYSEARCA:KWEB) was created for investors to tap into the growth of China’s internet sector. KWEB gives you access to Chinese equivalents of companies like Google, Facebook, Twitter, eBay, and Amazon in an earlier stage of their development. I believe KWEB offers a selection of superior companies. However, these come at a costly valuation, therefore I regard KWEB as a hold.

Fund Overview

KraneShares is an investment management company that primarily focuses on ETFs centered around China. They aim to provide diversified and specialized investment opportunities. KraneShares has 28 ETFs listed on U.S. markets, managing a total asset value of $7.30 billion. Out of these ETFs, only 12 have shown positive returns, and notably, many of them are relatively new products.

The CSI China Internet ETF is KraneShares’ largest and oldest ETF, holding nearly $5.7 billion in net assets. It doesn’t pay a dividend, any received dividends are reinvested. In this sector, dividends aren’t a primary focus. The ideal use of retained earnings is to drive substantial growth or enhance overall profitability. KWEB is focused on tracking Chinese Internet companies, just like a few similar ETFs: CQQQ, and EMQQ, which only have 55.7% of their assets in China explaining their positive returns.

The lowest performance of KWEB shouldn’t be immediately dismissed, as it might actually indicate a cheaper valuation and a stronger correlation to the ETF’s core objective. Each of these ETFs reveal a similar top composition, although the lower end of the ETF often includes stocks seemingly unrelated to its core theme. Each fund seemingly stretches the definition of “internet” stocks to fulfill diversification criteria. Most Chinese companies are bound to have some benefit to China’s emerging online market.

It’s crucial to maintain awareness of your investments because the classification of “Internet” stocks can be interpreted in many ways. Consider the MSCI China Tech 100 Index as a benchmark for Chinese technology performance for example. They are down 20% over the last five years and this is what they consider technology-related business.

Holdings Overview

KWEB offers a quite concentrated ETF, with its top 10 holdings accounting to 67.3% of the total ETF. It owns a total of 32 Chinese companies all engaged in the internet sector. I merged some holdings like JD health, iQIYI and Tencent Music as they are highly correlated to their majority shareholders. Let’s cover their portfolio to demonstrate what you’re actually exposed to.

Tencent

KWEB’s largest composite holding is Tencent (OTCPK:TCEHY), covering mostly the social media ecosystem. Their main app is WeChat, which combines messaging and mobile payments. A diverse business model combining advertising and fee-based income, is here for the long haul. Given China’s growth and the current valuation, it appears reasonably valued. They also hold a significant stake in KE Holdings, which the ETF also includes separately.

PDD Holdings

As is a usual problem with ETFs, the companies with the highest valuation also get the highest portfolio allocation. PDD Holdings (PDD) is known for its two e-commerce platforms Temu and Pinduoduo. In contrast to JD and Alibaba, their strategy is centered on removing the middleman by concentrating on less-educated customers in tier 4 cities through the utilization of group buying. They have been undergoing a period of high growth by targeting communities with lower income levels.

I believe their advantage is already priced in and at the current valuation high growth is projected. At a 30 PE ratio, the market is expecting the company to keep growing at 20% over the next years. This may very well be reasonable if no “unforeseen” challenges arise, but the question remains: why undertake the risk at this valuation? Frequently, smaller players are more likely to exceed expectations, accompanied by the potential for favorable returns

Alibaba

The tech giant Alibaba (BABA) is often perceived as undervalued. Ironically, it has sustained its undervalued status for nearly three years now, where it’s been continuously getting cheaper. I’ve heard of many potential catalysts that will finally unlock their value by now. However, the story has completely changed with the present valuation, as the market anticipates a modest 5-10% growth rate. They’re hugely diversified and have been continuously finding ways to keep investing their cash. People are no longer looking at the business to justify this undervaluation but at China, which we’ll cover later.

Meituan

Mainly known for the food delivery segment, Meituan (OTCPK:MPNGF) actually operates a diverse range of services by integrating a staggering 200 of them into a single SuperApp. For me, the situation is reminiscent of Pinduoduo-it’s definitely not a poor company, but the probability of surpassing the already lofty growth expectations seems slim.

Meituan’s earnings and profitability will depend largely on the consumer cycle. Small changes in variables for its valuation would already largely impact the stock price, making it nothing more than a leveraged bet on the macro in China in my opinion.

Baidu

Baidu (BIDU), often referred to as the Google of China, is a fascinating company that can be broadly categorized into two distinct segments. There’s the largely predictable Baidu core advertising segment, and then there are all its side ventures. Similar to Alibaba, I believe we get the core business at intrinsic value for around a 10% return. They are deeply immersed in tech trends such as AI and self-driving. If you are optimistic about the future profitability of these businesses, then Baidu’s returns have the potential to be substantial.

JD

Arguably the cheapest company of the bunch, JD (JD) currently sits at a 15 P/E. However, much of JD’s exceptional performance is somewhat obscured by its substantial capital expenditures aimed at constructing future infrastructure for its logistics, retail, and health businesses.

Once they reach a point where they can ease up on investments and fully capitalize on their infrastructure, there is a strong likelihood of net margin expansion. A rise from the current 2.3% net margin could yield exponential results for a company in the retail business. In the meantime, their valuation could realign with other Chinese internet companies. This assumption is partially supported by its enormous 13% free cash flow yield.

Remaining allocations

As allocation percentages decrease, the pool of remaining companies is primarily composed of less established ones. In my view, these investments can be divided into two categories:

1. High Valuation: It appears that numerous promising companies, likely to reward shareholders, are already incorporated into current valuations.

2. Uncertain Cashflows: For the second group, the fund’s investment thesis appears to have shifted from anticipating further growth to addressing uncertain cash flows. Consequently, many of these investments no longer meet the criteria for value investments.

The Problem With KWEB

KWEB has an expense ratio of 0.69%, while in reality, their top 10 holdings are 70% of the ETF. There are a few leading holdings that appear to be of high quality, due to the limited number of well-established players in the market. It looks like they threw in some extra positions on purpose just to make it easier to sell this ETF. It appears more diversified this way.

You’re not as diversified as you may think. Its annualized volatility over the past 10 years is 33.2%, with annualized returns of 8.5%. You may also not be avoiding the United States as much as you think. The correlation between China and the U.S. stocks over the past 20 years is 0.48. While it’s evident that navigating today’s global economy inevitably involves engagement with the United States, it’s worth emphasizing this point.

Common Risks

The most obvious problem with investing in an ETF is the inherent competition among its holdings, impacting overall returns. Each company shares the risk of competition taking market share. You’re investing in an Internet ETF where each company is betting on AI to improve their future earnings. This competitive dynamic may lead to a scenario where each stock anticipates gaining market share (literally impossible), potentially resulting in a significant decline in the total market capitalization.

In such an environment, consumers often stand to benefit. Despite the competitive landscape, I do hold the belief that given the current valuations, the overall growth potential of the sector will outweigh competitive pressure. Investing in their competitors simultaneously means overlooking the specific competitive advantages that certain companies hold. We’ll cover the valuation later.

Another common issue with ETFs is that pricier stocks often receive a higher allocation within the fund. As the price of a stock rises, its allocation percentage increases, which can disadvantage new owners of the ETF. The resulting lack of diversification isn’t necessarily problematic because the technology revolution tends to be led by a handful of companies, similar to the scenario seen in the United States.

China’s Economic Landscape

We’ve answered skeptical questions about China for each of the past 17 years. It was bank balance sheets. It was trade wars. And throughout this entire period, the end result has been that China’s GDP share, relative to the U.S., has gone up 5X. -Chase Coleman, Tiger Global Management

It’s self-evident that gaining exposure to the world’s largest growing economy is advantageous. The rising consumer base is propelled by many people entering the middle class, leading to increased purchasing power. This surge in consumer strength is driving numerous positive trends. Internet companies, in particular, are destined to profit from these favorable conditions.

Upon closer examination of Chinese crackdowns, they appear to be more logically driven than initially perceived. These actions seem motivated not by ideological considerations but by rational decisions. The implementation of anti-trust laws is not exclusive to China; it’s a global phenomenon. When observing China’s recent years, their approach has been notably capitalist, and the results indicate a successful execution of this strategy.

The prospect of China surpassing the U.S. as the world’s largest economy brings with it the potential for heightened tensions or the initiation of another trade war between the two nations. Such a scenario is feasible and could lead to global economic repercussions, impacting not only your Chinese stocks but the entire world.

The future is anticipated to maintain a considerable level of volatility, with its peaks and lows significantly influenced by the sentiments conveyed by Western investors. Our aim is to engage during periods with an all-time low in sentiment (currently at average levels), while concurrently ensuring that the business fundamentals remain solid.

Also noticeable is that China’s Debt to GDP ratio has increased rapidly over the past years (77.3% at the moment), increasing the risk for a larger economic slowdown. The possibility of China invading Taiwan in the future shouldn’t be neglected.

Valuation

KWEB is filled with premium companies, which is reflected in the valuation. China’s current valuation might appear inexpensive when compared to analogous U.S. equities, such as those on the Nasdaq. Let’s maintain an absolute perspective on this evaluation. Without any particular tailwinds in the future, KWEB seems fairly valued for a satisfactory return. This is confirmed by the ETF being at a historically average PE. The future PE ratio is marginally below the historical average.

Let’s compare valuations of the most established companies within the ETF, considering that established companies often come with a comparatively lower price-to-earnings ratio. As of writing:

	Tencent	PDD Hold.	Alibaba	Meituan	Baidu	JD	NetEase
Current PE	19.55	29.51	11.10	81.01	18.30	13.39	20.80
Forward PE	21.55	27.25	11.32	/	13.55	12.37	18.56

Click to enlarge

My expectation is for KWEB to outperform the S&P500 over the decade, yet that alone doesn’t justify it as a wise investment choice.

Conclusion

If you want to pay a slight premium for long-term exposure to China’s top-tier internet companies, then KWEB is for you. Over time, it has been demonstrated that investing in China either requires precise timing or demands considerable patience.

Investing in KWEB isn’t necessarily a poor choice, but there may be better options closer at hand. It could be more advantageous to consider purchasing the most affordable stocks on the list or steering clear of evidently expensive ones. This approach could offer similar volatility without incurring the ETF fee and sidestepping potentially speculative enterprises found at the lower end of the ETF.