KWEB: Upgrade To BUY, Too Cheap To Ignore (NYSEARCA:KWEB)

Introduction

Is China investible, that’s the first question one may ask before considering buying into this market. The answer is yes with two important caveats; 1. that the stocks have 20Fs i.e. some reasonable sense of disclosure and audited financials and 2. that the valuations compensate for the many other China factors. Those China risks are a lack of rule of law, the CCP (Chinese Communist Party) can and has changed regulation, policy, and directed capital as it sees fit and a company or negatively affected party has no recourse, no protection, the rules can change and there is little that can be done about it. The other factors are geopolitical, the “rivalry” with the West leads to protectionism, trade barriers, etc. that can and have made doing business difficult. Today I am following up on the KraneShares CSI China Internet ETF (NYSEARCA:KWEB) that I analyzed last December along with more recent articles on the iShares China Large-Cap ETF (FXI) and then PDD (PDD).

Summary

I am upgrading KWEB to buy from hold due to a combination of positive factors that more than compensate for China’s idiosyncratic risk. These factors include a lower relative valuation of 0.6x PEG (PE vs EPS growth), a consensus EPS growth upgrade of 5%, and a price target upgrade of 7% vs the December analysis, which combine for a 30% upside potential. In addition, the Chinese economy has bottomed and is gradually regaining growth led by exports and sentiment seems to have reached bottom.

The key risk to this upgrade is an escalation in geopolitics tensions, primarily via further trade tariffs or barriers that may cut into China’s export growth and would then damage domestic consumption that most of the stocks in the KWEB portfolio depend on to reach the above consensus growth and earnings.

Performance

Over the last 10 years, the Chinese tech sector has risen and crashed for a negative price gain of 20% which is in line with the Hang Seng index (Hong Kong) where most of the stocks trade. This is in stark contrast to India’s and Vietnam’s market gains. The primary cause of the crash is due to the CCP’s decision to increase scrutiny and regulation in the tech sector, along with others, that impacted investor confidence and company results. At the same time, China railed in overbuilding in the residential sector which has not been offset with growth via exports or domestic consumption leading to “weak” GDP growth that many view as a new normal.

Year to date in 20224 the ETF is up 11%, however, in the table below I calculated the price return of the current portfolio weights to have been a 13% decline with Tencent (OTCPK:TCEHY) down 27% and only four stocks had a positive return.

Portfolio Price Target & Revisions

Using consensus estimates for 94% of the portfolio AUM I calculated a 30% potential upside based on current analyst price targets to YE24 with PDD at +40%, and Alibaba’s (BABA) at +36% potential. Since my initial report, analysts have raised the target prices by 7% but BABA saw a 15% cut highlighting the company´s poor results and performance. Interestingly Tencent Music (TME) has the largest upgrade of 76% in its price target. In terms of weight changes, PPD was cut 50% to 7.8% from the top 14.8% most likely due to the stock’s performance in 2023 that required a rebalance based on free float-adjusted market cap.

EPS & Revisions

The market estimates a 25% EPS growth rate in the YE24-25 period. TAL the education stock and Alibaba Health have the highest estimated growth while PDD and Meituan Dianping (MEIT) are the portfolio heavyweights that contribute the most while Alibaba is the primary drag. However, as we have seen the forecast can suffer sharp corrections which calls into question the earnings visibility of the China tech sector. The analysts increased EPS for 2024 & 2025 by 5% and 4% on average with PPD a stand out with a 65% increase in estimated EPS.

Valuation

The KWEB portfolio is cheap at 15x PE (vs 30x historical) on YE24 estimates and more so with a PEG of 0.6x for the YE24-25 period. I used consensus estimates and weighted the PEG for 25% of YE24 EPS growth and 75% of YE25 EPS growth and in this manner, the relative valuation is capturing forward growth that may be considered more consistent long term. This valuation discount vs the Nasdaq which trades north of 1.8x PEG may be excessive but requires improved regulation or at least an extended time frame of positive macro and government news flow to re-rate.

Conclusion

I am upgrading KWEB to BUY from Hold. While my views on China’s risk have not changed it appears that the economy has bottomed as has sentiment. The current portfolio valuation is attractive given the generally positive earnings revisions. The main risk is major geopolitical events.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.