As China Tech Stocks Roar Back, a New Normal Will Test Upside

(Bloomberg) — Chinese tech stocks are suddenly back in Wall Street’s favor, but that doesn’t mean investors and analysts expect the sector to regain its former glory any time soon — if ever.

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From Goldman Sachs Group Inc. to Morgan Stanley, a growing number of strategists have made bullish calls following President Xi Jinping’s Covid Zero exit and vows to end a crackdown on the sector. The shifts have spurred a 60% rally in the Hang Seng Tech Index since an October trough, a world-beating feat even though the gauge’s market value is still half of its February 2021 peak.

While few doubt the worst is over, a bigger question looms on the sector’s fair valuation under a regulatory regime where free-wheeling growth is no longer tolerated, and as the industry matures.

“Chinese tech shares were once the easiest bet, and for most of the past decade you were able to win and see outperformance without doing much,” said Chen Da, managing director at Fortune Hill Asset Management Ltd. “It’s possible we’ll never see those times again.”

Outlook on the sector has gone through a sea change from early last year, when some of the biggest banks questioned whether the industry was even “investable.”

Having endured two straight years of losses, markets are brimming with hopes over the sector’s returns as signs grow that authorities are taking a more lenient stance. Guo Shuqing, party secretary of the People’s Bank of China, said this month that a regulatory overhaul is drawing to a close.

That, coupled with the reopening and thawing tensions with the US, has led to a flurry of price target upgrades across the sector including for Alibaba Group Holding Ltd. and Tencent Holdings Ltd., though targets fall far short of their highs.

New Normal

“There is a growth story to tell, but it’s not a very high rate of growth, one that is higher than utilities and more stable than cyclicals,” Fortune Hill’s Chen said. “I think it makes sense to look at the cohort more like consumer discretionary shares.”

Alibaba’s forward price-to-earnings ratio has only recently topped that of electricity provider CLP Holdings Ltd. E-book platform China Literature Ltd, a Tencent subsidiary, was valued as low as 11 times forward earnings at one point last year, below the one-year average for natural gas operator ENN Energy Holdings Ltd.

Meanwhile, the Hang Seng Tech Index’s valuation reached a peak of around 46 times forward earnings in 2021 and a low of 17 in October 2022, and currently stands at around 27 — comparable to consumer firms including Li Ning Co. and Budweiser Brewing Co APAC.

“There is going to be a greater discrepancy within the industry after best years of their growth are for the most part over,” said Zhuang Jiapeng, a fund manager at Shenzhen JM Capital Co. “The valuations we can expect to see under the new economic cycle will be very different depending on the company..”

For Goldman Sachs analyst including Ronald Keung, the internet sector still has another 20% upside, driven by valuation expansion after two years of contractions, and sales growth recovery over this year.

Lingering Risks

To be sure, tech is a fast-evolving space that could see a second growth curve with fresh developments, and the sheer size of China’s market makes it an attractive investment destination for some.

“When you look at how that sector’s been very batted down over the past few years, valuations also aren’t extremely stretched,” Christina Woon, investment director for Asian equities at abrdn plc, said in a Bloomberg TV interview. “So altogether that’s a reasonably compelling case to keep an eye on.”

But lingering regulatory risks may make assessing the sector’s fair value a complicated task. A sweeping clampdown across the sector has ended, but that’s not to say authorities are letting go of intense scrutiny.

On Friday, a report said government entities are set to take so-called “golden shares” in units of Alibaba and Tencent — potentially indicating greater state influence. Last month, the government published a new set of restrictions on private tutoring services for school students, increasing pressure on the so-called edtech firms.

“It’s only been a few months since we’ve stopped questioning them about investability, about regulatory weakness,” said David Perrett, co-head of Asian equities at M&G Investment Management. “The point is the regulatory concerns are in the price. And that’s very different from where they were two years ago.”

–With assistance from Aya Wagatsuma.