We all see the warning signs about the Chinese economy: debt has built up rapidly, bad debt is mounting, commodity consumption is voracious and real estate prices are falling.
This situation would be challenging at the best of times, but China and the United States are in the midst of an escalating trade war.
We don’t know exactly how the trade war or China’s economic situation will play out. What we do know, however, is that a Chinese debt spiral was as much of a risk 12 months ago as it is today. Yet 12 months ago, few investors were worried about it. Today, few investors are not worried about it.
This is enormously important. When a risk moves from ignored to feared, stocks that appear exposed to that risk fall in price. Sometimes prices fall so much that while the economic risk itself does not go away (the risk, say, of a severe economic slowdown in China), the risk of losing money over the life of the investment falls dramatically. Chinese investments are therefore likely to be much less risky today than they were 12 months ago, not more.
Consider NetEase, Inc., a Chinese online game and internet company that has seen its share price fall by more than 40 per cent from its peak at the end of 2017.
The company’s core business makes multiplayer online games. Many of these are free to play, and NetEase makes money by selling “virtual items” within the game. Paying for a better virtual sword, or a virtual outfit to commemorate a holiday, may seem strange to some, but to passionate players, the items are fun enough to be worth it, and NetEase has no shortage of passionate players. The company has multiple games with more than 100 million users, sometimes with more than a million playing at the same time. The founder and chief executive – who owns more than 40 per cent of the company – was once an avid gamer himself and, as the company has grown, he has insisted on first and foremost making games fun.
That’s good for players, and it’s also good business. Fun games attract more players. Those players interact online, investing time and effort into their characters, and building rich communities – making the games even more engaging and increasingly sticky. With regular updates and improvements, some of the company’s games have been running for more than a decade. The result is millions of people around the world who rely on the games as a key source of entertainment and are more than happy to pay a few bucks here and there to enhance the experience with virtual goods.
From a business owner’s perspective, that’s what matters for NetEase – developing fun games, attracting players, and keeping them engaged enough that they’re willing to spend money. With the largest R&D department in the industry, the company has earned a loyal user base by doing just that, and we believe its long-term earnings prospects are bright.
Now pause for a moment, and think about what we didn’t mention – the things that aren’t the core drivers of the business. Does the success of NetEase depend on Chinese shadow lending? Will its games be less fun if apartment prices drop in third-tier cities? Will people stop playing if tariffs rise?
We think not. But amid a swirl of other bad news – most of which we believe to be temporary – NetEase has joined the bear market decline in the MSCI China Index this year. After accounting for the US$4-billion of cash on the company’s balance sheet, its shares trade at about 15 times the profits of the core game business, an undemanding valuation for a company with attractive long-term growth potential.
Make no mistake, NetEase is not free of macroeconomic risk. Entertainment spending is discretionary, and so likely to fall if growth in China slows. But which entertainment spending? The games NetEase produces are an incredibly cheap form of entertainment, and so may be relatively resilient.
When everyone else is worried about something like a Chinese slowdown, that is when you are most likely to find a bargain. We are happy to let other investors worry about things they can neither predict nor control. As they do, we will spend our time trying to understand businesses, and we will worry about the one thing we can control – the price we pay for them.
Graeme Forster, PhD, CFA, is a portfolio manager at Orbis Investments and is responsible for the Orbis International Equity and Orbis Optimal Strategies.