KWEB ETF: China’s Increasing Control Ruining Its Tech Stocks

The new year began with stellar performance across most of 2022’s worst-performing market segments. One interesting example is the Chinese stock market, which has risen nearly 50% since November (FXI). The most extreme rebound gains have been seen in China’s technology sector, with the KraneShares China Internet ETF (NYSEARCA:KWEB) rising by a staggering ~75% since its fall trough. This rebound was backed by a sharp rise in the CNY/USD exchange rate and a general surge in technology stocks. See below:

KWEB is a notoriously volatile ETF that holds many speculative technology growth stocks. Since the fund owns Chinese companies, it carries significant risks from that country’s government policies and US policies toward China. These risks may impact the success of Chinese technology companies and the security of US investments in China. From 2021 to last year, the downturn in the Chinese economy, aided by extended COVID lockdowns, combined with a rise in internal and geopolitical risks in China, caused KWEB to lose around 80% of its value. However, the end of the “zero COVID” policy and the recent increase in the economic outlook have substantially reversed the trend, causing immense in-flows into the ETF.

Now that KWEB has reversed much of its losses, it may not have significant upside potential. While China’s economic outlook is improving, the country’s economy does not appear to be out of the woods. Since KWEB invests heavily in consumer discretionary internet companies, a slowdown in China’s economic growth will likely negatively impact these firms, particularly given their higher average valuations. The core bullish thesis behind KWEB is that it owns “China’s equivalent Amazon, eBay, Facebook, etc.” Still, fundamental differences between China’s economy and that of the US likely limit these firms’ growth potential. Still, under certain assumptions, KWEB may be a decent long-term growth opportunity relatively diversified from US equities.

Potential Of China’s “Great Firewall” Internet

KWEB invests in China-based companies that focus on the internet or internet-related technology. These firms are trading as ADRs on the Hong Kong or US stock market. Nearly half of KWEB’s holdings are in consumer discretionary companies like Alibaba (BABA), “JD.com” (JD), and the food delivery firm Meituan (OTCPK:MPNGF). The next largest segment, at 37% of holdings, is communications, with firms like Tencent (OTCPK:TCEHY), NetEase (NTES), and Baidu (BIDU). These large companies are essentially China’s equivalent of the largest US technology firms, like Amazon, Google, Uber, etc., but generally less established.

As noted in KWEB’s factsheet, total Chinese retail internet sales are over twice as high as in the US, and the country’s internet population is over 3X larger. Over the past decade, the total population of China’s middle class has become more significant than that of the United States at over 400M. This group is changing, or at least threatening, China’s rigid political structure, which generally remains anti-capitalistic and opposed to the everyday freedoms of western countries. I believe this remains the most significant long-term and immediate risk to KWEB as it is unclear if China wishes to allow its economic structure to become similar to the US’s. The fundamental bet behind KWEB is that its holding companies will become cash-cow “juggernauts” like their US technology giant equivalents.

This transition will require China to make fundamental changes to its internet that may not occur. On the one hand, the expansion of China’s middle class and the internet has caused more information to flow past the country’s firewall. However, instead of embracing the change, China’s government has responded by aggressively increasing internet censorship, surveillance, and arrests, to try to halt the change. Chinese citizens are breaking the firewall, but it remains unclear if they can break it entirely or make it even more substantial.

In my opinion, for KWEB to have long-term potential, the Chinese government will need to change to allow for a greater unrestricted flow of capital and information. KWEB has risen and fallen many times since its inception in 2013, but it remains at nearly the same price it was then despite immense growth in China’s technology economy and middle class. The larger and older Chinese index fund (FXI) has also made essentially no gains since its 2004 inception, though it has had dramatic bull and bear markets.

While US stocks have bull and bear markets, they dependably rise in the long run; that is fundamentally not the case in China despite its significantly greater economic growth pace. This issue stems from various causes, including currency deprecation for trade protection and efforts to block foreign ownership of Chinese companies. Most importantly, Chinese public stocks do not have the “shareholder value” orientation embedded in most stock markets. Since the Chinese communist party has far greater legal authority and direct control over many Chinese companies, these firms’ primary obligation is to the Chinese communist party and its goals. When those goals align with capitalist economic growth, Chinese stocks benefit; but the party will almost always intervene in its companies for its own ends.

With the sharp rise of Alibaba and Tencent, many investors believed that the era might be ending as China allowed these companies to grow organically and internationally. However, the communist party recently made efforts that give it direct control over virtually all sizeable Chinese technology companies via ownership of “golden shares.” Many entrepreneurs who created these giants, such as Jack Ma and others, have seemingly been exiled as the party reasserts control over its technology space. The old dream of an “open China” that emerged under Deng Xiaoping appears to be ending as Xi acts to remove political rivals from power and consolidate authority.

Fundamentally, KWEB has offered no lasting returns to its investors despite immense economic growth, particularly in its technology sector and middle class. The Chinese government allowed its technology sector ample freedom until it became large enough to threaten the country’s rigid structures. Xi’s administration has dramatically increased its control over the past three years and limited most of KWEB’s constituent companies’ capacity to act independently. While China’s reopening may improve the profitability of these firms in the short-term, China’s government appears to have no aim to be “open,”; greatly threatening these companies’ long-term potential as they cannot act in shareholders’ best interest.

Value Potential in KWEB?

I believe investors should not underestimate the power of the Chinese government to take full control over its internet technology sector such that US investors will see no long-term benefits. While that is a significant risk to KWEB, the recent wave of anti-lockdown protests in China indicates the populace yearns for freedom. As those protests became large enough, the CCP had little choice but to change its direction or risk widespread revolt. Suppose China’s population continues to question its largest institution(s). In that case, there is hope that China’s “Great Firewall” will eventually fall, allowing KWEB’s companies to become free enterprises with free access to international markets, capital, and information. The profits of many of KWEB’s constituents would likely rise substantially if that occurs.

KWEB had a weighted average forward “P/E” of around 22-23X at the end of 2022. The fund is priced about the same as it was then, so its average valuation is likely the same. The Nasdaq 100 index has a forward “P/E” of 24X today, so KWEB’s valuation is essentially the same as Nasdaq’s. China and US technology companies have faced a sharp slowdown in EPS growth, with many seeing earnings slipping over the past year. Globally, the era of significant technology company growth, promoted by widespread smartphone adoption, may end. While KWEB’s valuation has declined, it is still within its typical historical range despite elevated sector risks.

Many stocks in KWEB, such as Alibaba and Baidu, recently jumped into the “artificial intelligence” chatbot trend. Many of these companies were chasing the cryptocurrency hype and seemingly deviating from crypto toward new popular trends. While this technology appears likely to become more popular and commercialized, I would not assume this trend will result in strong EPS growth anytime soon. Most companies in KWEB are near equivalents to older US firms and seem to follow their patterns. Fundamentally, if large Chinese technology giants wish to compete internationally, they must develop their innovations instead of attempting to recreate those from other companies.

The Bottom Line

Now that KWEB has risen dramatically, I am not particularly bullish on the ETF. Assuming KWEB’s holdings have decent growth potential, the ETF appears to be fairly valued today. Of course, much of its future will rely on the Chinese communist party and its geopolitical stances toward China. In my view, for KWEB’s holdings to maintain success, the CCP will need to reduce its control over its technology sector dramatically. Further, the US (and its peers) will need to become more favorable toward China and not threaten to ban Chinese apps. Of course, it seems likely that US attitudes toward Chinese companies will improve if China reduces its communist focus.

While many seem to believe China will inevitably transition toward a free market economy, its government is seemingly going in the opposite direction today, increasing control over technology companies and restricting the freedoms of its entrepreneurs. Put simply, communism does not make for suitable investments – as evidenced by the eternal stagnation of virtually all Chinese stocks. If that changes, then KWEB may be a solid long-term investment; but until then, I would only buy the ETF if its valuation falls back to unreasonably low levels.