Tencent Holdings (TCEHY) Deep Dive Analysis - George Gammon

Tencent Holdings (TCEHY)
                Deep Dive Analysis
August 30, 2020

This report focuses on macro updates, discusses the latest portfolio changes,
and then analyzes Tencent, the fast-growing Chinese internet titan.

U.S. Business Cycle Update
Here’s a recap of current economic conditions in the United States, divided
into a few sections.

Jobless Claims Update

The latest weekly numbers for jobless claims are that 1 million people filed
initial claims in the most recent week, while 14.5 million people filed
continued claims.

Chart Source: St. Louis Fed

At the peak level of economic shutdown, nearly 25 million continued claims
were filed, so more than 10 million of them fortunately went back to work
since then.

Continued jobless claims at 14.5 million are coming off somewhat slowly, and
even at these reduced levels, remain more than twice as high as during the
peak of the 2009 unemployment crisis.

COVID-19

For some good news, COVID-19 daily deaths in the United States continue to
stabilize and decrease:

Chart Source: Worldometer

The United States has among the most cumulative death rates per capita from
the virus among large developed countries, and we still continue to have

elevated new cases and new deaths compared to most peers, but the arc points
firmly down now.

Some people naturally question the number of COVID-19 deaths.

For example, if someone dies in a hospital for unrelated reasons, can’t they be
mistakenly or intentionally classified as a COVID-19 death, especially if the
hospital gets more reimbursement for COVID-19 deaths than many other
types of deaths? Maybe the U.S. just has higher COVID-19 deaths because we
test so much now, or because we classify the deaths differently?

Unfortunately, while that’s a logical line of thinking, collaborative evidence
using a separate measurement method suggests that’s not the case.

If we ignore the type of deaths and just looked at how many excess deaths
occurred in 2020 from all causes, compared to what should statistically occur,
the number actually slightly exceeds the number of official COVID-19 deaths,
and in a precise shape and time that is obviously related to COVID-19:

Chart Source: MarketWatch

By this count, there were more excess deaths during 2020 than the number of
deaths official attributed to COVID-19, by roughly 10% or so. This tells us,
through a totally different way of measuring it, that the number of reported
COVID-19 deaths is relatively accurate, and if anything, understates it slightly.

And this makes sense, because due to the limited nature of testing, there
would naturally be more people that die from COVID-19 that were never
tested and never confirmed to have had it and thus were not classified as
having died from it, than people who didn’t die of COVID-19 but were
mistakenly or intentionally classified as having died from it anyway.

And it’s a bigger excess death count than the flu, by a lot. Most flu seasons are
mild (already accounted for in statistical annual death rates during those
months), and some are particularly bad (exceeding normal annual death
rates), but COVID-19 is notably worse than a bad flu season, even though
unusual containment measures and changes in peoples’ behavior were used to
control its spread:

Chart Source: MarketWatch

The good news, however, is that the overall kill rate of the virus remains quite
low.

As of this writing, based on the U.S. official number of cumulative confirmed
cases and deaths, the virus has about a 3% kill rate, and that mostly comes
from people with pre-existing conditions that make them vulnerable to it. If
nursing homes and other vulnerable populations are protected, the fatality
rate goes way down.

And because the majority of people were not tested, it is broadly considered
very likely that far more people have had it than the confirmed cases, which if
true means the death rate is way lower than 3%.

How bad the virus is exactly, depends on perspective, even if we just focus on
numbers in the United States.

On one hand, with a 187,000 death count and rising, this virus has so far
killed:

  •   More than 60x as many Americans as the 9/11 terrorist attacks did.
  •   More than 30x as many Americans as died fighting in the wars in
      Afghanistian and Iraq combined.
  •   About as many Americans as died fighting in World War I and the
      Vietnam War combined.
  •   Nearly half as many Americans as died fighting in World War II.

On the other hand, less than 0.06% of the American population has died from
the virus.

This big psychological divergence in absolute numbers and percentages makes
it a very complicated sociopolitical issue to report and discuss. It is easy to
spin it in various ways to make it either look worse or not as bad compared to
reality, in order to suit various competing agendas across the political
spectrum.

If we look broadly internationally, most countries now have the virus under
control according to reported numbers. Brazil was late, but they are starting to
contain it. India is the last major country where it’s still rising, but the rate of
change is beginning to improve, and looks set to hopefully peak in September.
Let’s see.

Jackson Hole: Fed Chair Speech

The big financial news this week involved Federal Reserve Chairman Jerome
Powell’s speech at the Economic Policy Symposium in (virtual) Jackson Hole
on Thursday.

Every year, central bankers and other folks in high finance from around the
U.S. and from international locations gather in Jackson Hole, Wyoming, to
discuss monetary policy and other economic trends. This year’s event was held
virtually due to the impact of the virus on travel.

For months now, the Fed has been saying that they will review their policy
framework and provide updated forward guidance on how they will operate.
News broke early last week that the Fed’s chairman Jerome Powell would give
a “pivotal” speech at the symposium about the Fed’s new policy, particularly in
regards to inflation.

As a long-term background for people who don’t follow this closely, the Fed
has two congressional mandates, which are known as the Fed’s “dual
mandate”:

  1. Price stability
  2. Maximum employment

Historically, the Fed tightens monetary conditions (raises interest rates) to
contain inflation, and loosens monetary conditions (lowers interest rates
and/or uses quantitative easing, aka “money printing”) to improve
employment conditions. So, how tight or loose they want to be depends on
whether inflation or employment is more of a concern at the moment.

Back in 2012, the Fed introduced an annual inflation target of 2%, which was
roughly a ceiling on how much inflation can reach before it is considered too
high and requiring more management to ensure price stability. They measure
inflation with “core personal consumption expenditures” or PCE for short,
which is a basket of price estimates that uses some substitution methods and
policies that many argue understates actual cost of living. It’s quantifiable,
even if not perfectly representative. And it factors out volatile things like food
and energy. So, it is what it is.

Ever since the current economic slowdown began back in 2018, the Fed began
referring to this more heavily as a “symmetric target of 2%”, meaning that
since inflation as measured by PCE averaged only about 1.5% over the past

decade, notably below their target, they are willing to let it overshoot to maybe
2.5-3% for a little while so that the long-term average is closer to 2%.

And in FOMC meeting minutes in 2020 so far, Fed officials confirmed that
they want to let inflation overshoot and run hot for some time, in response to
such a long period of low inflation according to that measure, and because of
the scale of the disinflationary shock that happened from the economic
shutdown and job losses.

Well, at the symposium, Powell solidified this symmetric approach by
emphasizing average inflation targeting, and announced that they will let
inflation run hot next time before actively trying to contain it.

Here’s the core paragraph of Powell’s speech:

We have also made important changes with regard to the price-stability side
of our mandate. Our longer-run goal continues to be an inflation rate of 2
percent. Our statement emphasizes that our actions to achieve both sides of
our dual mandate will be most effective if longer-term inflation expectations
remain well anchored at 2 percent. However, if inflation runs below 2
percent following economic downturns but never moves above 2 percent
even when the economy is strong, then, over time, inflation will average less
than 2 percent. Households and businesses will come to expect this result,
meaning that inflation expectations would tend to move below our inflation
goal and pull realized inflation down. To prevent this outcome and the
adverse dynamics that could ensue, our new statement indicates that we will
seek to achieve inflation that averages 2 percent over time. Therefore,
following periods when inflation has been running below 2 percent,
appropriate monetary policy will likely aim to achieve inflation moderately
above 2 percent for some time.

-Jerome Powell, Jackson Hole, August 2020
In 2018 and 2019, Powell and the FOMC began raising interest rates, even
though PCE inflation was below 2.2%, because employment was pretty high.
In other words, with employment at ideal levels and inflation as they measure
it bouncing around near the high end of their target (even though it had
averaged below their target over the past decade), Powell began trying to give
the Fed additional ammo to fight the next recession, and raised rates
preemptively.

The problem, in Powell’s view, was that the Fed cuts interest rates to fight
recessions and boost employment levels, but the interest rate was already
near-zero when he took over as the Fed’s chairman. In his mind, he had to
raise rates so that whenever the next recession comes, he’d be able to cut rates
back to zero. If rates are already near-zero when a recession hits, he is more
limited in the actions he can take.

In Powell’s speech, he basically said they won’t do this next time. They won’t
preemptively raise rates at early signs of rising inflation and decent
employment levels. They will let inflation run hot before they consider trying
to contain it. In most ways, Powell didn’t really say anything new, at least for
folks that follow FOMC meeting minutes. This was already what the Fed was
planning, as they specifically said at meetings that they would likely let
inflation overshoot its target level in the coming cycle.

Lawrence McDonald, former head of Macro Strategy at Soc Gen (one of
France’s largest investment banks), summarized the speech well in meme
form (using a popular meme template based on American Chopper):

And… that’s it.

The Fed can’t create inflation unilaterally, unless they use extreme measures
that they probably won’t resort to. With their normal tools, including rate
manipulation and bond purchases, they can only choose how much to contain
inflation, and they’ve signaled in meeting minutes and now at virtual Jackson
Hole, that they are not going to contain inflation as quickly in the next cycle.

Even if inflation runs hot, they will be slow to raise rates, and will probably use
yield curve control at some point to keep Treasury rates well below the
prevailing inflation level, for quite some time. But they can’t create inflation
with their normal tools.

In multiple prior speeches, Powell has suggested that Congress should do
more fiscal spending to boost the economy, which is a true source of inflation
pressure. Congress can create inflation more-so than the Fed.

In order to create inflation in the current high-debt environment, it would
require massive fiscal deficit-spending that the Fed mostly monetizes, and for
the Fed to stand-by and it let it all run hot. This is what happened in March
2020, except it was in response to a deflationary shock and solvency crisis, so
the net result was reflationary (moving inflation back up from a briefly very
low level to normal levels) rather than outright inflationary (driving up
inflation to higher-than-normal levels).

It’s unusual for a Fed chair, who is traditionally supposed to be apolitical, to
refer so directly to fiscal policy, but being low on ammo in terms of monetary
policy tools at zero interest rates, that is what he has done a number of times
this year.

The Fed will monetize deficit spending as needed by buying Treasury
securities and containing rates, but the Fed itself can’t spend into the
economy. Only Congress can spend into the economy. The Fed’s role is now
secondary, having run firmly into the zero bound of interest rates and having
bought a large number of bonds by expanding the monetary base.

In the two trading days after the speech last week, inflation breakevens in the
Treasury market went up slightly, Treasury bond yields went up slightly, and
the dollar experienced a day of volatility and then fell a bit vs other major

currencies. The moves weren’t huge because, again, all of this was telegraphed,
and nothing was truly new or surprising.

Fiscal Cliff: Still Falling

Extra fiscal spending pretty much ended at the end of July, and that’s a topic
we’ve been covering in these reports for months.

From April through July, people received stimulus checks and extra
unemployment benefits, and small businesses received loans that turn into
grants, nearly $3 trillion in free grant money overall, but most of that stopped
by the end of July. Some of it happened with a lag; unemployment benefits
attributed to previous weeks still went out to people into mid-August.

Now, at the end of August, the economy has been operating for a couple weeks
in “non-fiscal” mode. Unemployed people are not receiving additional federal
unemployment benefits, and businesses are pretty much on their own.

Small business revenue peaked in the beginning of July and has since been on
a downtrend. July consumer confidence reached a new cycle low after
enjoying a brief bounce.

Chart Source: Advisor Perspectives

If this situation continues with high unemployment and low government
stimulus, the natural results of a major recession will play out, with many
people and businesses unable to pay rent, which trickles up to landlords and
banks, and results in a broad solvency crisis and many defaults.

So far, national personal income was up in 2020 (rather than down as in a
normal recession), due to increased government transfer payments that more
than offset the loss of normal income. And that led to retail sales also being up
in 2020 (largely lead by e-commerce), because consumers have that
government cash to spend, even as employment conditions, imports, exports,
industrial production, and capital spending are all down as per what we’d
expect from a severe recession. That divergence between incomes going up
and economic activity going down is not inherently sustainable, unless
government spending artificially continues to sustain it.

Both political parties want another round of stimulus. The Republicans and
President want about $1 trillion in stimulus, mainly targeting businesses and
consumer stimulus checks again. The Democrats want $3 trillion in stimulus,
targeting state budgets and larger consumer stimulus checks this time. Both
sides have signaled compromise; Democrats are willing to go down to $2
trillion, and Trump is willing to go up to $1.3 trillion. Political events related
to the upcoming election and unrelated to stimulus, largely involving the Post
Office, have further slowed down these negotiations.

The situation remains in gridlock, and so the economy has gone off the “fiscal
cliff”.

Analysts don’t expect S&P 500 earnings and revenue to surpass 2019 highs
until 2022, even though the stock market has already reached new record
highs in 2020, due to increases in valuation.

As long as that fiscal gridlock remains, a disinflationary pressure and broad
solvency risks grow. The Fed’s balance sheet stopped increasing nearly three
months ago. Broad money supply stopped increasing about a month ago. The
stock market and consumer finances are no longer held up by “money
printing” at this particular time.

Equities and other risk assets, which have kept going up, are vulnerable for
correction in this environment.

A Global Look
The global economy is somewhat in sync when it comes to rebounding. Here is
manufacturing PMIs for Europe, Japan, and China, for example:

Chart Source: TradingEconomics.com

Everyone experienced an economic crash in March/April as the economy
shutdown. China was ahead, then Europe and broader Asia, then the United
States, and then several emerging markets.

Japan has been somewhat weak, while China has been reasonably strong. For
the United States, many metrics are reasonably good, but the reported
unemployment situation is far higher than most of our peers, due to the way
our system is structured.

Latest Portfolio Changes
The S&P 500, having broken over 3,500, is currently at the most overbought
level in terms of daily RSI since early 2018.

The S&P 500 recently became overbought based on RSI in early 2020, had the
severe March 2020 correction, rebounded into a June overbought state,
corrected and consolidated a bit, and is now at all-time highs in a bigger
overbought state.

These overbought conditions, combined with near record-low put/call ratios,
and the fact that we’re off the fiscal cliff and can’t point to money-printing as
propping up the index, sets the stage for another potential consolidation or
correction.

A correction or pullback is not guaranteed to happen here, although the index
is over-stretched on multiple technical and fundamental metrics relative to the
damaged economy. It’s best thought of as a probability distribution, and the
likelihood of a correction or consolidation is increasing here, especially with
the fiscal taps closed at the moment.

No Limits IB Portfolio:

As I described I would do in last week’s extra report, I bought TCEHY and sold
BBL this week.

Fortress Income Portfolio:

For early next week, I plan to sell SYY and buy BTI.

BTI is unusually cheap, has a high yield, and despite the long-term decline in
tobacco usage, tobacco companies have outperformed the broad equity market
over the past 25 years because they are cheap and send most of their cash back
to shareholders while maintaining high returns on invested capital.

As a note, I don’t personally invest in tobacco companies. There are very few
industries that I avoid outright, and tobacco companies are the key industry I
avoid. So, while I think BTI is a great value/dividend investment at this price
level as part of a diversified portfolio, I would not buy it in my large personal
Schwab account, for example.

However, the model portfolios are mainly meant for members, rather than
myself, so I am willing to add BTI to the Fortress Income Portfolio because I

think it objectively increases the risk-adjusted forward return potential of the
portfolio at this price level for the stock, and will not overlay my own personal
preferences to those portfolios if they conflict with my forward return
expectations.

Investors each have their own decisions about what investments they might
choose to exclude for reasons other than risk-adjusted forward return
potential and dividend income.

Other Holdings

In my Schwab/Fidelity personal accounts, I did a bit of portfolio pruning.

I sold TRV, RSXJ, and SBUX. I have nothing against them and am not acutely
bearish, but at this time felt that they no longer warrant individual positions.

I bought TCEHY, EBAY, AMGN, and RSX. The first three stocks have all been
subjects of deep dive analysis reports and were already in other portfolios, and
RSX is the iShares Russian stock ETF. Russia faces heightened sanction risk at
the current time but remains an interesting long-term opportunity based on
my global opportunities investment report and based on past analysis of the
largest Russian companies.

All of my portfolios, and the global opportunities investment report, are
available in the Google Drive. I update portfolio lists ahead of a purchase in
the Google Drive.

Tencent Holdings (TCEHY) Deep-Dive
Analysis
This report focuses on Tencent as an investment idea, but a bit of background
is needed first.

Chinese Tech overview

Years ago, the emerging markets index was characterized as being mainly a
commodity play, with rather low-value industries making up the bulk of it.

However, over the past 10+ years, the emerging market index has reached a
greater percentage of internet and tech companies than the global developed
market index, largely thanks to China, South Korea, Taiwan, India, and to a
lesser extent, Singapore and others.

The MSCI emerging market index is now 49% composed of the information
technology, consumer discretionary, and communication services sectors,
which encompasses various technology, e-commerce, and online media
companies. This compares favorably to MSCI’s EAFE (developed ex-USA
international markets) index which has just 25% in those sectors, and the
American market that has 34% in those sectors.

Several Chinese companies, like Alibaba, Tencent, JD.com, Baidu, Huawei,
and others, have been a big part of this change, and in several ways they mimic
the American “FAANG” group of internet companies that includes Facebook,
Amazon, Apple, Alphabet, Netflix, and informally Microsoft (but at lower
relative valuations).

Alibaba is similar to Amazon and Netflix and Paypal, in the sense that it offers
e-commerce and cloud platforms and a large e-payment network. JD.com is
also big in the e-commerce space.

Tencent is similar to Facebook, Paypal, Netflix, and aspects of Microsoft, in
the sense that it provides a social network, gaming, and a large e-payment
network.

Baidu and Sohu are similar to Alphabet in the sense that they focus on online
searching and some AI development, although Tencent has been entering the
search market as well, by operating its own search engine and offering a
buyout of Sohu.

Huawei is like a smaller combo of Apple and Cisco, in the sense that it offers
consumer electronics and various networking equipment.

Alibaba and Tencent together have a pretty firm duopoly on Chinese payment
systems, thanks to the network effect. There are many funny stories of
foreigners going to China, with a wallet full of Chinese cash and international
credit cards, and yet street vendors and other businesses don’t accept those
payments, and only want Alipay or WeChat Pay from a mobile device.

Developed markets gradually went from cash to credit/debt cards to mobile
payment systems over the past several decades, and is still firmly in the
credit/debit card dominance period. Emerging markets went from cash,
mostly skipped over physical credit cards, and are now leading the way on
mobile payment adoption as a percentage of payments. This includes China,
India, and others. With relatively low GDP per capita, not everyone has a PC in
developing markets, but basically everyone has a smartphone. Those
developing Asian economies came of age economically in the era of the
smartphone.

And yet, Alibaba has a market cap of under $800 billion, and Tencent is under
$700 billion, while Apple, Alphabet, Amazon, and Microsoft are all well over
$1 trillion each (with Apple being above $2 trillion, and Microsoft not far
behind).

So, with China’s large population that is more than 4x as high as the
population of the United States, there is plenty of growth potential in the
internet, media, and e-commerce space in Chinese stocks over the next
decade. They are big, but have room to get a lot bigger.

Tencent Focus

Tencent Holdings, founded in 1998, is China’s second largest company by
market capitalization after Alibaba. Investors can buy their shares on the
Hong Kong Stock Exchange, but for this report, the American ADR with ticker
TCEHY is the baseline security that I’ll use here. It’s available over-the-
counter, rather than on a major American exchange like Alibaba or JD.com,
despite its massive size.

Tencent operates two social networks, WeChat and QQ, which generate
advertising revenue. By extension, they also operate WeChat Pay, which has
become one of China’s largest mobile payment methods along with Alipay.
Tencent is also a large producer and distributor of games in China and
globally, and is the world’s largest video game company.

Here’s Tencent’s overview, from their 2020 interim results presentation:

In addition to their own core platforms, Tencent owns key equity stakes in a
variety of global gaming companies and other internet/software companies.

Notably, Tencent owns:

  •   9% of Swedish streaming and media company Spotify
  •   5% of American electric car and solar producer Tesla
  •   20% of Chinese e-commerce giant JD.com

•   100% of Riot Games (the American producer of League of Legends, one
      of the world’s most popular games)
  •   40% of Epic Games (the American producer of Fortnite, the world’s most
      profitable game of 2019)
  •   5% of French video game giant Ubisoft
  •   5% of American video game giant Activision Blizzard
  •   25% of Sea Limited, Singaporean e-commerce and gaming fast-growing
      giant that focuses on Southeast Asia (Singapore, Malaysia, Thailand, the
      Philippines, Taiwan)
  •   Stakes in a variety of other companies, including multiple international
      game producers, plus Discord, Reddit, and more.

Although China has a rather large corporate debt bubble centered around its
real estate sector, Tencent as an internet company is basically net debt-free.

They have roughly as much cash as debt, and their gross debt/EBITDA ratio is
less than 1.5x.

Tencent’s returns on invested capital are routinely in the double-digits, while
revenue growth is very strong. By virtually all metrics, it’s an extremely
successful business.

Valuation Analysis

Tencent stock is relatively expensive, but has high expected forward return
potential and a strong balance sheet, and so overall, is fairly-valued for long-
term positive returns. Its chart looks like how a lot of FAAANG stocks looked
3-5 years ago.

Here’s the F.A.S.T. Graph:

We can see that in early 2018, the stock got a bit ahead of itself, and then for
two years the company’s fundamentals consolidated sideways. China faced the
U.S.-China trade war situation, and Tencent specifically faced a nearly year-
long freeze by Chinese regulators on gaming approvals.

If the company meets analyst-consensus growth expectations, the fair value
for TCEHY by the end of 2022 is over $90/share, compared to $70/share
today.

Of course, the company could grow slower than consensus expectations, or its
valuation could decline below historical norms despite reaching analyst
consensus targets, so such a share price is not for certain. Therefore, the $90
target is merely a baseline target based on fundamentals, and assumes a
valuation that is similar to (but actually a bit lower than) today’s valuation.

However, Tencent has a big lock on Chinese internet, payment, and media
exposure. It trades for a smaller market cap than its American counterparts,
despite the fact that China has more than 4x the population as the United
States. Tencent’s long-term upward potential over the 2020’s decade is
immense. Although such an outcome is not certain, there is little to stop it
from potentially becoming a $1 trillion company within 3 years, and a $1.5+
trillion company in the years after that, subject to valuation changes.

The company’s price-to-sales ratio (one of the most useful metrics for a fast-
growing high-margin e-business) is in line with its historical average, after
having become rather expensive in early 2018:

Here is a StockDelver model for Tencent, using 18% growth over the next five
years, 12% growth for the five years after that, and a proposed sale P/E in ten
years that is only 25x, compared to today’s level of 42x:

Chart Source: StockDelver

Besides its core wholly-owned businesses, Tencent’s most promising
investments include its stakes in Spotify, JD.com, and Sea Ltd.

Here’s JD.com’s FAST Graph:

JD.com is a Chinese e-commerce giant that is a smaller but faster-growing
competitor to China’s largest company Alibaba, and is beginning to enter what
seems to be its profitable phase now. If things go well (and no revelation of
fraud or other curve balls), there’s nothing stopping JD.com from one-day
becoming a half-trillion dollar company, of which Tencent’s stake would be
worth $100 billion. Even half that would be a big gain from current levels.

Spotify’s revenue is soaring, and so is Sea Limited’s. Tencent has been a strong
allocator of capital so far, and these are two companies to watch in particular
along with JD.com.

Tencent’s founder, CEO, and Chairman is Ma Huateng. With a net worth of
over $50 billion, he is currently China’s richest person, and is currently in his
late 40’s, so he has plenty of long-term potential in relation to Tencent
leadership.

Overall, Tencent has a multi-pronged set of growth opportunities in Mainland
China and multiple countries in Southeast Asia from a perspective of social
networks, gaming, e-commerce, and payments, and more broadly the global
gaming industry outside of that super-region. As a group, this region has

faster-growing GDP than fully-developed markets, and the long-term potential
is very large.

It would likely require a major external disruption for Tencent (or some big
revelation of fraud or other internal tail risk) to not eventually blow past the
$1 trillion USD market capitalization threshold in the years ahead, although
various normal outcomes can curtail or delay that advancement to some
degree.

Company Risks

The risk situation for this stock is longer than normal, because there are plenty
of risks to cover.

Competition Risk

Many of Tencent’s businesses, such as WeChat for social expression and
online payment, enjoy huge economic moats in China, and operate in
oligopoly-like status with strong network effects. Other parts of their business,
like video games and other media, must continually compete with other
companies with more vulnerability.

Tencent’s video game interests also compete with various game developers
globally, Tencent’s equity stake in JD.com competes with Alibaba and e-
commerce companies, and Tencent’s stake in Tesla competes with various car
manufacturers globally.

Currency Risk

Foreign investors have currency risk if they invest in Chinese companies.

The CNY has been in a relatively tight band vs USD over the past decade, but
various events could trigger a breakout or breakdown. Tencent could do well
in CNY terms, for example, but if the CNY weakens vs the dollar or euro or
whatever your home currency happens to be, it could do worse as priced in
your currency. The opposite possibility is true as well.

China Regulatory Risk

While most countries have some degree of mild regulation around media, such
as ratings on games and movies related to violence or sexual content and so
forth, China is not a free country and can outright disapprove the release of
various media for political reasons or other reasons, which can be problematic
for a media company like Tencent. No domestic or foreign publisher can
publish a movie or game in China on the open market without China’s
regulatory approval.

For the better part of a year starting in 2018, China overhauled its regulatory
process, and put a freeze on approving all new games. This contributed to
Tencent’s earnings and stock price slump during the past couple years. In
addition to managing politically-sensitive content, China’s regulators
expressed concern with widespread video game addiction, and so they also
created gaming curfews making it so that minors can only play 90 minutes of
games on weekdays and 180 minutes on weekend days, and not between the
hours of 10pm and 8am.

In addition to broad regulator risk, if at any point Tencent’s executives are
out-of-favor by the Chinese Communist Party, their business results may be
impacted by any number of regulatory actions against them. As one of China’s
largest companies, China has a strong incentive for Tencent to grow and
prosper, but only to the extent that it doesn’t conflict with the interests of their
political party and authoritarian rule.

Fraud Risk

Publicly-traded Chinese companies have a higher rate of fraud than U.S.
companies, European companies, or Japanese companies.

I consider Tencent to be somewhat lower on the risk list among Chinese
companies. This is because they own some of the strongest businesses in
China (it’s well-known how strong their social, payment, online, and media
businesses are), and they regularly make foreign deals by using capital to buy
stakes in non-Chinese companies, which is good evidence of their liquidity.

However, as a Chinese business, Tencent still inherently has a higher risk of
something fraudulent occurring which would have a material impact to
investors, than, say, a company like Microsoft. Between the two, I would
personally trust Tencent over Tesla, though. It’s all somewhat relative.

In addition, China’s government-reported macroeconomic data is vulnerable
to a sizable degree of manipulation as well, and investors often use third-party
data sources to try to collaborate Chinese macroeconomic data where possible.

This risk can be managed with appropriate position-sizing to account for tail
risks related to fraud.

Natural Catastrophe Risk

Over the past few months, China’s Three Gorges Dam has been in the news,
and not for good reasons. The dam is so big that it measurably affected the
rotation speed of our planet when constructed, so it’s not a structure that you
want to be in the news for unfavorable reasons.

It’s the largest dam in the world, and China has experienced epic rains at
levels not seen for decades, which have flooded portions of the country and
put pressure on the dam. The historically unusual amount of rain has tested
the limits of what the dam was designed for, with generational highs in rain
levels. According to dam operators as well as satellite images, the dam started
to become a bit distorted a couple years ago, and it’s getting more attention in
2020, but dam operators say that it is safe.

If this dam were to ever have a catastrophic failure, either due to a natural
break or due to a terrorist or foreign military strike, a large portion of China’s
densely-packed population area would be flooded, including several major
cities, and electricity generation would be negatively affected. A few hundred
million people would be impacted to varying degrees, and there would be
severe economic implications for China specifically, and by extension a large
portion of the highly-interconnected global economy.

In such a scenario, the macroeconomic damage to China’s economy could
weigh notably on Tencent’s performance, and introduce some major
sociopolitical risks for China’s ruling regime.

Cold War Risk

China and the United States are increasingly in a “cold war” type of scenario
with each other, as competing economic and political major powers. These

include tariffs, regulatory actions, and some degree of economic de-coupling
and capital controls.

Each country has the ability to perform major economic damage to each other,
like the U.S. blocking Chinese exports, or China banning Apple products from
their country, and things like that, if political differences deteriorate.

The bulk of Tencent’s business is relatively immune to U.S. economic
decisions, but some areas are vulnerable. Trump recently banned WeChat
transactions in the United States, for example, which itself is an
understandable decision because China bans many American social platforms.

However, this ban had unintended consequences and was quickly verbally
scaled back a bit, because the plan was quickly lobbied against by the likes of
Apple, Walmart, and other mega-cap U.S. companies due to the fact that
WeChat is the platform for how a lot of U.S. companies communicate and
transact with their Chinese suppliers. And Chinese Americans use it to
communicate and transact with family and friends in China. But for the most
part, it’s money that speaks.

WeChat has rather little usage in the United States as a percentage of its total
userbase (which is mostly in China), so this hasn’t really been financially
material for Tencent. It’s currently a question mark for U.S. companies with
Chinese supply chains, and for Chinese Americans that wish to communicate
with Chinese family and friends. Those are the groups for whom it could be
impactful.

The United States could also block future Tencent acquisitions of American
businesses, although such a move could have reprisal from China by blocking
or otherwise harming some American companies that operate there.

In an extreme case, the United States authorities could block Americans from
investing in Chinese companies via sanctions, which would have a dramatic
impact on the index fund industry, Chinese equity valuations, and many other
things. It could reduce Chinese stock valuations and force Americans to sell at
an inopportune time for a loss, even if the fundamentals of the businesses are
otherwise solid.

It’s a messy situation worth monitoring over time. These risks can be managed
with appropriate position sizing and jurisdiction diversification.

Summary
The U.S. economy is at a crossroads due to running over the fiscal cliff. There
is a fiscal gridlock with an upcoming U.S. election in a little over two months.

This year has the most negative economic impact since the 1930’s on the U.S.
economy and most of the world economy, and the system was held up over the
past four months due to record amounts of fiscal stimulus at a level relative to
GDP that has not been seen since World War II. Different countries have
responded to it in different ways, but most responses were quite large.

In the United States, fiscal spending was large enough to fully replace lost
income on a national scale for four months, but tapered off into August, so
now there are more disinflationry and insolvency outcomes on the table.

China went through the virus effects first, and came out relatively intact, and
in particular the internet companies like Tencent are well-positioned to
prosper for years to come due to being less economically sensitive and
benefiting from the ongoing digital shift, and without being notably
overvalued.

Compared to their American counterparts, Chinese internet stocks like
Tencent are reasonably priced relative to their growth rates, for investors that
are willing to diversify and take on some Chinese accounting risk and
geopolitical risk with appropriate position sizing relative to their own risk
profile.

I’m bullish on a variety of Chinese internet firms, with Tencent being my
preferred risk/reward play at the current time as part of a diversified portfolio.

_____

All of the analysis in this research report is presented for informational
purposes about investments in general and does not constitute investment
advice.

Individuals have unique circumstances, goals, and risk tolerances, so you
should consult a certified investment professional and/or do you own due
diligence before making investment decisions. Certified professionals can
provide individualized investment advice tailored to your unique situation.
This research report is for general investment information only, is not
individualized, and as such does not constitute investment advice.

Every effort is made to ensure that the research content in this report is
accurate, but accuracy cannot be guaranteed and all information is presented
“as is”. Investors should consult multiple sources of information when
analyzing investments.

Investments may lose value. Investors should use proper diversification and
maintain appropriate position sizes when managing their investments.

Best regards,