Tech uptrend belies risk, but bodes well for future


Despite COVID-19-related stock market fluctuations, the ChiNext index, which tracks China’s innovative startup-heavy board, had risen 12.93 percent this year to 2030.58 points as of Friday.

This came in spite of a 5.33 percent decline in China’s benchmark Shanghai Composite Index over the same period, as well as a 19.74 percent drop in the Nasdaq index, the ChiNext’s counterpart in the United States.

Some mainland-listed tech firms now have price-to-earnings ratios as high as more than 100, and many mutual funds targeted at tech shares were sold out on the very first day of subscription.

The bullish performance of tech shares has sparked meaningful questions: How to justify investors’ passion in Chinese tech shares, which are risky in nature in a virus-stricken world where people should have sought certainty? And will the uptrend continue?

To answer the questions, one should first acknowledge the fact that the epidemic will likely be a short-term variable and may have limited impact on long-term economic prospects and therefore company fundamentals.

Therefore, it is the valuation expansion, instead of any tipping points in corporate earnings growth, that holds the key. In fact, the epidemic has fueled expectation of an easier liquidity condition, which in turn pushed the valuation of tech shares higher.

As the outbreak worsened, the market expected monetary and fiscal stimulus would be rolled out both at home and abroad to surf the economy through the epidemic.

On March 3, the US Federal Reserve cut policy rate by half a percentage point to tackle “evolving risks to economic activity” brought by the novel coronavirus. Before the cut, the market had already expected three rate cuts by the Fed this year as a response to the epidemic.

Investors also expected that China’s central bank, the People’s Bank of China, will maintain ample liquidity in the financial system and guide market rates lower via continuous open market operations such as reverse repos and medium-term lending facilities.

Tech shares then become the biggest beneficiary of the bet over monetary easing, as they typically have higher Beta. Or, prices of tech shares are more sensitive to changes in liquidity conditions or interest rate than others.

Historical performances have shown that once a large amount of liquidity is pumped into the market, mainland-listed tech shares and medium-to small-cap innovative firms would far outrun the market.

Also, investors gave tech shares higher valuations as technology has assumed greater importance due to the epidemic. Confined to their homes due to virus-containment measures, investors now recognize the value of online consumption and offices more than ever before. The need for building a domestically controlled electronics industry chain has also become more urgent as the virus spreads in South Korea and Japan, key exporters to China’s electronics industry.

In the medium term, I expect the uptrend in tech shares underpinned by liquidity to continue, given that a weak global economy, a sluggish recovery in demand and a controllable inflation level will probably remain. These factors will sustain liquidity at a still high level both at home and abroad.

Now is the best time for tech shares. The market is tolerant of high valuation of tech shares, after a globally easy monetary environment over the past 10 years as well as the nation’s push to reforms of the capital market in order to support technology upgrades.

A high tolerance for tech share valuation will be a boon for tech firms to develop themselves.

Tech firms in China have long faced a typical dilemma between the need to expand investment and research expenditures and the difficulty to get financing. Without adequate properties and factories as collateral, tech firms could find it extremely hard to get financing from the dominant banking system.

A stock market friendly to high valuations of tech firms will help them get out of this predicament, sustain cash flow and elevate the chance of survival.

Tech firms could get direct financing from initial public offerings and refinancing channels after becoming public firms, while more venture capital will be motivated by the strong secondary market performance to invest in tech startups.

All this would be critical for future growth of the Chinese economy.

If we look at the so-called three drivers of short-term economic growth, investment and exports are both under pressure, while consumption is expected to hold up and drive up growth. Technology, in turn, is a catalyst for consumption growth.

Online retail, industry chains of smartphones and 5G devices, internet of things and other technology-driven sectors have become the most vibrant parts of China’s consumer market.

Meanwhile, from the mid-to long-run perspective, technology is undoubtedly the engine of economic development, especially as China is seeking the transformation from quantity-driven growth to a more efficient and sustainable development model.

Therefore, the bullish trend in tech shares will ease the difficulty for tech firms to get financing, and therefore help promote short-term recovery in economic growth and long-term quality development.

That said, investors should still bear in mind the inherent risks of tech firms. Drastic fluctuations in Chinese tech shares can be expected in the long term.

Tech shares are oriented toward the future, while future correlates with uncertainty. In their initial development stages, what tech firms usually face are unstable cash flows, business models yet to prove feasible and hence a harsh operating condition.

The chance of failure is high and the fluctuations in corporate earnings can be expected. Many firms with broken cash flows and unsuccessful research results will get delisted from the A-share market in the future, just like on the Nasdaq market. Only a tiny proportion of the listed tech firms that create real value for economic development will survive and receive sustainable high valuations.

Therefore, volatility in stock prices of tech firms will magnify over time as the focus returns to company fundamentals. Historically, tech shares have seen higher volatility in stock prices than the sector of consumer staples that has stable profitability.

Also, just as ample liquidity conditions push up the valuations of tech shares, a tightening monetary environment can pull them back.

If the expectation of acceleration in inflation rises and forces monetary authorities to take the additional liquidity back to reserve, a major correction in Chinese tech shares may be inevitable. Let’s not forget that the Fed’s accelerated monetary tightening in the fourth quarter of 2018 did trigger a 30-percent drop in US tech shares.

The writer is the managing director of CreditEase Wealth Management, an arm of Beijing-based global fintech conglomerate CreditEase.