An Update On My 2 Favorite Chinese Stocks...

Jimmy Butts's picture

Tuesday, July 16, 2019 - 2:30pm

by Jimmy Butts

We need to talk about China... 

And no, I'm not referring to the ongoing trade spat with the country. While that is important and it will be touched on, that is something you can read about anywhere. I want to talk about the country's importance in the broader global economy, its impact on our portfolio over at Top Stock Advisor, and specifically our direct exposure through two holdings: Alibaba (NYSE: BABA) and Tencent (OTC: TCEHY)

Before we dive into our holdings, let's take a step back and look at the bigger landscape of the country...

Massive Size = Massive Opportunity
In terms of land mass, China and the United States are close in size. However, China boasts nearly 1.4 billion people, which dwarfs the roughly 325 million folks in America. Its economy, as measured by Gross Domestic Product (GDP), sits at $13.6 trillion, which is second only to the United States' $20.6 trillion.

China and the United States trade more goods -- nearly $700 billion last year -- than any other two countries in the world.

But let's go back to the country's population... 1.4 billion citizens. That is a lot of people. And a key reason why nearly all companies invest heavily to expand into China. They want to tap into this massive market. To put this into context, last year, approximately 69% of Amazon's (Nasdaq: AMZN) $233 billion in sales came from the United States. In other words, 325 million people spent more than $160 billion on Amazon alone. That averages out to just shy of $500 per person. 

Now imagine if Amazon could replicate that success with China's 1.4 billion people. Even if those folks spent one-fifth the amount Americans did. That equates to an additional $140 billion in sales (currently only around 2% of Amazon's total sales are from China). Of course, this is much easier said than done. Amazon would have to compete with the likes of Alibaba, but it gives you an idea of the total addressable market that has companies desperately fighting. 

A Tough Market To Crack
Tapping into China's market is difficult due to government regulations. Many of the things we might take for granted in the United States are outlawed for Chinese citizens. For example, if we need to look something up or learn more about something we might "Google" it or read about it on Wikipedia. 

However, in mainland China, Google (along with many of its affiliates, Gmail, Google Maps, etc.) are blocked by the government. So are Wikipedia, YouTube and more than 10,000 other websites. 

Perhaps more astonishing is the fact that Chinese citizens cannot (legally) trade U.S. shares. They can trade companies listed on the Hong Kong exchange through so-called Stock Connect schemes linking Hong Kong and the Shanghai and Shenzhen stock exchanges. However, Alibaba is listed on the New York Stock Exchange, meaning Chinese citizens can't invest in one of its largest, most beloved, companies. 

BABA logoBut with Alibaba's latest moves, it seems like that's about to change...

A few weeks ago, I told my Top Stock Advisor readers about Alibaba's recent proposal for a 1-for-8 stock split. The stock split was overwhelmingly approved at the firm's annual shareholder meeting on July 15. 

At first glance, the stock split doesn't raise too much suspicion. But there's more. On June 13, Reuters reported that Alibaba filed for a Hong Kong listing that could raise up to $20 billion. Keep in mind that Alibaba holds the record for the world's largest initial public offering at $25 billion in New York five years ago. 

Alibaba doesn't really need the $20 billion-plus in additional funding. The company has $31.5 billion in cash in its coffers and about $20 billion in debt. It generated more than $15 billion in free cash flow last year. In short, the company doesn't struggle in the cash department. It doesn't need to raise capital. The real (assumed) reason that Alibaba wants to list on the Hong Kong exchange is to give mainland Chinese investors the opportunity to invest in the company. The stock split would lower its nominal share price, which is nearly mandatory to allow more access for more Chinese investors. That's because stocks on the Hong Kong exchange trade in "board lots," and every stock has an individual board lot size. For example, Tencent's lot size is 100, meaning your purchases must be in multiples of 100. You can't buy 50 shares -- it must be 100, 200, 300, etc. 

A stock split would greatly reduce the capital commitment needed to invest in Alibaba, one of China's greatest companies. 

A World-Class Business
The point is, making it easier to invest in a company is always a good thing. It's also another reason for us to hold on to the stock, despite the concern about U.S.-China relations. 
As a quick refresher, Alibaba is what I called the "Amazon of China" when I first wrote about it in July 2017. But it's actually much more than just a global ecommerce player. The company has its hands in everything from media (it owns the South China Morning Post) to finance to mobile payments. 

It still collects most of its sales from online retail. The company grew revenue by 48.7% to more than $56 billion over its last fiscal year, which ended in March. That's incredible growth for such a large company. Earnings jumped 35% year-over-year and the company generated $22.5 billion in operating cash flow. And Alibaba is showing no signs of slowing down. Analysts expect the company to pull in more than $73.6 billion in sales this year, which would represent 31% year-over-year growth.

TCEHY logoDon't Forget About Tencent...
Our other Chinese holding, Tencent (TCEHY), is also a wonderful business. It, too, continues to grow at a nice clip. Revenue climbed 34% to more than $47.2 billion in 2018 over 2017 and its bottom-line figure increased 12% to over $11.8 billion. 

Tencent is the world's largest gaming company by revenue, generating more than $19 billion in sales from gaming in 2018. Next largest is Sony, which pulled in $14.2 billion. The company's portfolio includes titles such as "League of Legends" as well as "Arena of Valor." It also has a 40% stake in "Fortnite" publisher Epic Games. 

Action To Take
China will continue to garner headlines and be a major focal point for investors and companies, alike. It is simply too hard to ignore the market potential that the country offers, even with the risks of strict government intervention (and market volatility). 

And there's little doubt that Alibaba is a world-class business, which is why we own it. We're up by about 24% since my original recommendation about a year ago, but if you didn't get in back then, I'm still comfortable owning the stock under $170 per share. 

As for Tencent, we are up close to 30%. I continue to like it, but the company does have a much higher exposure to the whims of Chinese government regulations. China has cracked down on the release of video games in an effort to curb how much playing time kids have. This has been a headwind for Tencent, but I continue to like the stock under $40 per share. 

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Jimmy Butts does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.