I am strongly of the view we have seen the bottom of the emerging market sell off and it’s now time to increase exposure to the best structural growth stocks in Asia. It’s time to pick up the BATS…Baidu (NASDAQ: BIDU), Alibaba (NYSE: BABA), Tencent (HKG: 0700) and Samsung (KRX: 005930).
Firstly, I want to again explain what happened in emerging markets (EM) and why you are getting an opportunity to buy structural Asian growth stocks very cheaply.
I thought it would be best to quote directly from the number one rated macroeconomic strategy team at Vanda Securities, based in Singapore. They issued a note this week titled “5 EM charts that scream buy”. The full note and chart pack is below.
1. EM equities have experienced the largest outflows in post-crisis. More than half of the money that flowed into the asset class between Jan 2016 and Jan 2018 has already left. Both in absolute and relative terms, outflows have been much larger than in previous EM sell offs, like the taper tantrum or the run-up to the Fed’s hiking cycle.
2. Cash levels in EM equity funds are at the highest level since 2016. Bank of America’s latest Fund Manager Survey (FMS) brought up two key ideas: Cash levels rose above the 10-year average again and US equity positioning was the most crowded in years. How to reconcile the two? It was only EM and international equity managers that raised cash allocations in Q2, US managers’ conviction on the bull market did not falter. The chart below shows that cash levels for EM equity funds rose from 3.2% to 3.9% from March to June, whereas their US peers only raised them by 10 basis points.
3. Short interest on the iShares MSCI Emerging Markets exchange traded fund (EEM) surged above 17% of shares outstanding. There have only been a few instances in which shorts surpassed current levels and none of them lasted long.
4. Long positions in H-shares have been completely wiped out. A common way to gauge the level of speculation in Chinese futures is to compare their daily volume to the outstanding open interest on the contract. Holding positions overnight requires pledging a larger margin requirement so investors tend to engage in heavy intraday trading as a result. During the spectacular H-share rally in January, the volume to outstanding interest ratio exploded, pointing to a euphoria in the investor base. In Q3, the ratio has dropped below the post-crisis average.
5. Mainland support for H-shares has evaporated in Q2 and Q3. Since the start of stock connect [the collaboration between Hong Kong, Shanghai and Shenzhen Stock Exchange started in late 2014], mainland investors had been a constant source of support for H-shares. In over three years, there hadn’t been any major outflows over 3-month periods [until now].
Wipe-out and/or buying opportunity
That is an accurate summary of a complete wipe-out in emerging markets (EM) but anyone with contrarian blood in their body should be excited by the buying opportunity it presents.
With 17% of the EEM ETF shorted in New York, the first thing to do is look at the largest stock weightings of that ETF. As money flows out of the ETF, the biggest weightings in the ETF get sold in a price indiscriminate way.
The three largest weightings of the EEM ETF are Tencent (5%), Alibaba (4%) and Samsung (3.8%). Baidu (1.2%) is the 7th largest holding of the ETF, which means the BATS alone represent 14%.
My view is that the highest quality, longest-duration, highest-barrier-to-entry, large-cap Asian structural growth stocks are now very cheap due to this ETF outflow. I believe it’s a wonderful time to buy the BATS.
Bat for BATS
The China Internet sector has fallen 10% year-to-date, underperforming MSCI China’s 7% year-to-date decline. The index has roughly returned to July 2017’s level.
The valuation of the China Internet sector as whole is cheap at a PEG ratio of 0.9 times. Many stocks are trading close to, or at, trough valuations.
Tencent and Alibaba are trading at historical average P/E, but on price to sales are at one standard deviation below average, as new blockbuster businesses like entertainment, cloud, and e-finance are loss making. These new businesses are free options at current valuation.
Although volatility will remain elevated until the US mid-terms are out of the way, downside risks should be limited, given the magnitude of the positioning unwind and the clear and present value apparent in the BATS.
Structural growth stocks are rarely cheap on price-to-growth ratios. Being able to buy the Chinese Internet sector on a PEG ratio of less than 1 times is cheap. The market, due to EEM ETF redemptions and shorts, is paying you to take the risk. The margin of safety is now high and I believe over the next five years there should be 50% to 100% capital gains in the BATS and the next tier of Chinese internet stocks such as JD.COM, 58.COM and MOMO to name just a few.
Asian exposure
In my opinion, all investment portfolios should have some exposure to Asian structural growth tech stocks. Asia is where technology and population growth collide and it is rare to be able to buy these great structural growth companies at discounts to their intrinsic value.
Buying the BATS now reminds me very strongly of buying BHP at $15 a few years ago in a similar capitulation event. If you have more than a one-week investment view, can tolerate some short-term volatility, then I see buying BATS now as no different to buying BHP at $15 at the crescendo of commodity negativity three years ago. The rewards also have the potential to be very similar.
As Lord Rothschild said, “buy on cannons, sell on victory trumpets”. Right now, the cannons are firing at the BATS.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.