As internet regulation and the turning point of the pandemic gradually become clear, the easing of earnings pressure may present a bottom-fishing investment opportunity.

Hong Weekly Author | Liang Xing

The recent CPPCC convened a special consultative meeting to further encourage the expansion and strengthening of the digital economy. The internet industry is currently experiencing 'two major turning points'—regulatory certainty and the pandemic turning point. At present, regulation encourages the healthy development trend of the platform economy, and as the pandemic gradually recovers, there is hope to return to the original growth trajectory.

Policy bottom emerges

Short-term earnings under pressure, but long-term outlook positive

Under the influence of international tensions and repeated outbreaks in various regions, this year's macroeconomic growth is under pressure. Internet platforms, as an important part of online consumption, are also one of the key drivers for stabilizing annual economic growth. In recent years, domestic internet regulation has tightened, including antitrust, content regulation, and information security regulation, which have created some short-term pressures on the industry's development.

However, since the beginning of this year, the policy turning point for the internet industry has gradually been established, with several high-level meetings continuously signaling a marginal improvement in the attitude towards platform economy rectification. Under the gradual recovery of regulatory signals, the valuation recovery opportunities of previously oversold internet companies deserve attention.

Recently, internet companies have gradually disclosed their Q1 financial reports. Overall, most companies are facing significant operational pressures due to complex policies and economic environments. For instance, Tencent reported total operating revenue of 135.471 billion yuan, flat compared to the same period last year; however, adjusted net profit reached 25.545 billion yuan, down 23% year-over-year. The weaker-than-expected performance was mainly due to slower commercialization of gaming and financial businesses amid regulatory and pandemic pressures, weakening advertising demand during the economic cycle, and increased investment amid intensifying competition.

In addition, due to pandemic lockdowns, food delivery and in-store dining sectors saw a significant decline in orders. For platforms like Meituan, although Q1 results have not yet been disclosed, a short-term decline is unavoidable. However, based on the experience from 2020, once control measures are relaxed, both supply and demand for food delivery will see a sustained and healthy recovery. Moreover, food delivery business has better risk resistance compared to other industries. In the long term, food delivery remains a major consumer trend with considerable room for growth.

Regarding short-video platforms, Kuaishou achieved revenue of 21.07 billion yuan in Q1, up 23.8% year-over-year, with an adjusted net loss of 3.72 billion yuan. During Q1, recurring outbreaks in certain regions and the macroeconomic downturn led to reduced advertising spending by advertisers. Meanwhile, the pandemic caused pressure on logistics and warehousing, affecting e-commerce operations on short video platforms. However, in the medium to long term, short videos and live streaming formats demonstrate stronger presentation and commercial efficiency, hence offering relatively high growth certainty.

Industry valuations and performance are expected to recover

Index fund allocation opportunities emerge

As internet regulatory policies become more normalized, the market's marginal sensitivity to policy changes is expected to decrease. The internet industry has a certain consumer-oriented nature and has been affected by the pandemic and macro consumption factors; it is anticipated that performance in the first and second quarters will face pressure. However, as the pandemic improves and the economy rebounds in the second half of the year, the recovery in consumption could extend to sectors such as advertising and e-commerce, providing positive catalysts for internet companies' earnings.

There are many internet-related ETFs on the market that can serve as investment targets for bottom-up portfolio allocation. Take the China Internet ETF as an example: the China Internet 50 Index it tracks currently has a PE ratio of 40.04, which is at only the 18.85th percentile over the past five years. The index selects 50 Chinese internet companies listed on overseas exchanges as sample stocks, including internet companies listed in both Hong Kong and U.S. markets.

However, in recent years, external regulatory uncertainties have arisen for U.S.-listed Chinese stocks. In March, the U.S. Securities and Exchange Commission included the first five companies on the 'preliminary identification list' under the Holding Foreign Companies Accountable Act, triggering panic selling in the market. Currently, about 100 Chinese stocks are on this list, with another 40 Chinese companies being moved to the 2021 fiscal year’s 'definitive identification list.'

Under the premise that China and the U.S. are likely to reach some form of regulatory cooperation, Chinese stocks meeting regulatory requirements may be able to retain their U.S. listings, but secondary listings or dual primary listings in Hong Kong are also potential options. To date, 27 Chinese stocks have returned to the Hong Kong market, and it is estimated that dozens of other Chinese stocks meet the criteria for returning to the Hong Kong market within the next three to five years. Secondary and dual primary listings of U.S. shares and Hong Kong shares are fully exchangeable, priced adequately, and theoretically do not involve discounts upon conversion. Therefore, the Hong Kong stock market could become a key hub for investing in Chinese internet companies.

An investable option for Hong Kong-listed internet companies is the Hong Kong Tech ETF. It tracks the CSI Hong Kong Connect Technology Index, selecting 50 leading technology companies with large market capitalizations, higher R&D investments, and strong revenue growth from the pool of eligible Hong Kong stocks as index samples. Among its top ten weightings are Tencent, Meituan, Xiaomi, and Kuaishou. Unlike ETFs that invest in U.S. stocks requiring QDII channels, this ETF uses the Hong Kong Stock Connect quota, avoiding foreign exchange restrictions and allowing T+0 trading.

Investors can also consider the Computer ETF. Leading internet companies are poised to strengthen and expand, with expenditures expected to gradually recover, benefiting the computer industry. The resurgence of the pandemic in the first quarter had a significant impact on the industry, causing delayed revenue recognition, which led to a sharp decline in gross margin. Additionally, the rapid expansion of the industry's workforce in 2021 caused R&D expenses to grow steadily in the first quarter. Under the influence of these two factors, net margins fell sharply, reducing the industry’s profitability. As the pandemic subsides, industry performance growth is expected to rebound gradually.

(This article was published in the May 28 issue of Red Weekly. The views expressed herein are solely those of the author and do not represent the position of Red Weekly. Mentioned stocks are for illustrative analysis only and should not be considered as buy or sell recommendations.)

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