Is the Risk Worth the Reward?

Chinese stocks have been falling practically all year. The list of unknowns has grown to levels to make even the most value-conscious growth investor throw in the towel on the Chinese market as a whole.

Though Chinese tech stocks seem rich in value, the perceived risks of investing in the Chinese market have grown considerably with time. Delisting fears alone may be too great for any cautious investor to get in on such popular internet behemoths like Alibaba (NYSE: BABA), Tencent Holdings (OTC: TCEHY), or Baidu (NASDAQ: BIDU).

Smaller, higher-growth tech stocks (think Pinduoduo (NASDAQ:PDD)) seem even harder to get behind, given their amplified volatility and greater risk in the face of a global economic downturn. Also, let’s not forget about the risk of accounting irregularities.

The Difficult-to-Fathom Risks of Investing in Chinese Stocks

Though the list of worries seems to grow, rather than shrink, by the day, uneasy investors may be better off forgoing the high-growth market altogether. For those ready and willing to embrace the added regulatory risks of owning Chinese stocks, I think there’s much value to be had.

At the end of the day, China is one of the fastest-growing markets out there, and the dominance of its top tech companies could rival that of the American big tech companies we all know and love. Indeed, being at the mercy of the Chinese government is never a great feeling. Regulatory risks are difficult to factor into a Chinese stock’s valuation.

Regardless, I think a lot of such regulatory risk is baked into shares. Any unforeseen easing of regulations could induce massive upside across the board. Of course, speculating on when such exogenous events will occur is a fool’s game. If you’ve got the time horizon (at least 10 years) and are comfortable (preferably with some experience) in catching fast-falling knives, actively avoiding Chinese stocks could leave a lot of long-term growth on the table.

How to Reduce Risk When Buying Chinese Internet Stocks

The Chinese internet stocks, I believe, are worth dollar-cost averaging (DCA) into as they crumble. Their growth profiles could have the potential to be unmatched, especially once the Chinese economy recovers and firms like Alibaba look to international markets to add to their growth.

Now, the Chinese market already has a world of growth opportunities for a firm like Alibaba, as it pursues new market verticals. Like American big tech companies, top Chinese internet giants are expanding their businesses to encompass new markets. Payments, video games, e-commerce, hardware, and all the sort, the Chinese stocks do, in many ways, have growth profiles that resemble the big tech companies on steroids.

The only piece of hair on their long-term stories lies in regulatory risks. Chinese companies must comply with regulations, or the penalties for skating offside could be enormous. Last year, Alibaba was made an example as it took a $2.8 billion fine to the chin for anti-competitive behavior. Alibaba has committed to change, and other Chinese tech firms are likely to follow.

There’s no way to truly eliminate regulatory risks. For investors, the best way to go, I think, is with China’s top tech giants. Alibaba and Tencent are two top dogs that are down around 78% and 68% from their all-time highs.

Fundamentals suggest both firms are deeply undervalued. That said, regulatory risk warrants a lofty discount on shares versus the fundamentals. It’s hard to tell how much regulatory discount shares should command.

At this juncture, it seems like such risks are at a high point, with Chinese stocks down around the same as a Cathie Wood innovation stock. With valuations in the gutter, Chinese stocks may be worth a contrarian bet for those who understand the magnitude of the risks they’ll bear.

The Bottom Line on Chinese Stocks

Though there are so many intriguing options in the Chinese market, I think dollar-cost averaging into mega-cap or market-weighted ETFs like the KraneShares CSI China Internet ETF (KWEB) are the best way to go for those willing to stomach amplified pain going into a recession year.

The risks with Chinese stocks are high and hard to fathom. However, so too are the potential rewards.

An ETF option would be best for investors looking for a smoother transition should major US exchange delistings cause a conversion of US-traded shares to Hong Kong shares.

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