With Chinese stocks under fire these days, it's unclear exactly what effect the renewed U.S.-China tensions may have on their ultimate valuations. While many Chinese tech stocks have sold off after the scandal involving Luckin Coffee and the Senate's passage of the Hold Foreign Companies Accountable Act, it's entirely possible these distractions have opened up an opportunity in high-quality Chinese companies. After all, many Chinese stocks were under pressure throughout 2018 as the trade war escalated, only to appreciate handsomely in 2019 (and for some, even in this pandemic-affected year).

One of those hard-hit China tech stocks last week was blue chip tech giant Tencent Holdings (OTC:TCEH.Y). Yet Tencent actually reported quite solid first-quarter results recently. Its main online games, WeChat social media, and streaming video businesses spiked, offsetting some weakness in payments and the cloud amid the coronavirus pandemic.

And besides this solid performance, there's another, more hidden reason that Tencent might be woefully undervalued today.

Closeup of a businessman holding a magnifying glass to an electronic tablet.

Image source: Getty Images.

Tencent's "investees" are crushing it

As one of China's oldest and largest tech giants, Tencent employs a capital allocation strategy of routinely plowing excess profits into various start-ups and younger tech companies. And not only in the Chinese internet space, but also in several Western tech companies as well.

Today, many of these start-ups aren't so small anymore. In fact, several are now large-cap companies in their own right, with Tencent still retaining significant ownership shares. They're listed below, with the Chinese companies first:

Tencent Investees

Tencent  Stake

Company Market Cap 

Tencent's Proportional Value 

One- Year Gains

Meituan Dianping (OTC:MPNG.F)

20.9%

$88.3 billion

$18.4 billion

136.6%

JD.com (NASDAQ:JD)

17.9%

$73 billion

$13.1 billion

76.8%

Pinduoduo (NASDAQ:PDD)

16.5%

$82.3 billion

$13.6 billion

235.8%

Vipshop Holdings (NYSE:VIPS)

9.7%

$10.1 billion

$1 billion

106.1%

Tesla (NASDAQ:TSLA)

5%

$151.4 billion

$7.6 billion

323.8%

Snap (NYSE:SNAP)

12%

$25.5 billion

$3.1 billion

56.2%

Spotify Technology (NYSE:SPOT)

4.3%

$35.4 billion

$1.5 billion

49.6%

Total Tencent investees 

12.5%

$466 billion

$58.2 billion

137.9%

Tencent

 

$503.2 billion

 

22.3%

Data source: company filings; Y!charts. Table by author.

As you can see, Tencent's "investees" (its term for the companies it invests in) have absolutely crushed the market over the past year, rising on a weighted-average basis by 137.9%! And yet, over the past year, Tencent's own stock has only appreciated 22.3%. The investees themselves have gained about $33.7 billion in value, the biggest contributor being Tencent's 20%-plus stake in Meituan-Dianping, the dominant food-delivery platform and digital marketplace for services in China.

Meituan's contributions are followed by the rise of Pinduoduo, the discount e-commerce player whose meteoric rise over the past year has made it an even bigger contributor to Tencent than established e-commerce and logistics whiz JD.com. Finally, the fourth-biggest contributor, after JD.com, has been Tesla. Tencent only owns a 5% stake of the company (the smallest portion of any investee above, save for Spotify), yet Tesla's ridiculous 323% gains over the past year have made it a material contributor as well.

Should Tencent have gained more?

While the investees have gained roughly $33.7 billion in value in a year, Tencent overall has only gained about $94 billion in market value. So basically, Tencent's investees have accounted for over a third of Tencent's gains over the past year. And remember that Tencent also has stakes in many unlisted companies, such as Didi Chuxing, the largest ride-hailing platform in China, and dozens of other start-ups. 

Assuming Tencent's mere 14% or so stock appreciation over the past when excluding the gains by its public-market investees, its performance seems to badly lag most other Chinese internet companies listed above. And that also includes fellow giant Alibaba's 25.7% gain over the past year.

Though Tencent is large and may struggle to grow at the hyper-speed of a Meituan or Pinduoduo, it's not only putting up solid revenue growth, but also profit expansion as well (something the highfliers listed above aren't really doing yet).

Last quarter, Tencent's revenue grew 26% and its adjusted operating profit (excluding the gains from the investees above) increased 25%, with adjusted net profit rising 29%. Adjusted free cash flow increased a whopping 133%, thought that was no doubt due to delays in some capital spending and media production amid the pandemic.

The fact that Tencent was able to grow revenue 26% while keeping margins stable, even in a quarter in which China's GDP contracted by 6.8% due to COVID-19, is a testament to Tencent's resilient business model and cash flow generation.  Thus, it seems Tencent may be more deserving of higher annual share-price gains, especially given the success of other Chinese internet companies during that time.

Today, Tencent trades at a 38.9 P/E ratio, but its public-market investments alone are over 11% of its market capitalization. So not counting those investments, Tencent trades at the low-30s trailing P/E. Given the long-term growth prospects for Tencent's various businesses in online games, social media, streaming video, music, cloud computing, and electronic payments, that seems like more than a fair price to pay for such a high-quality tech giant, especially as interest rates hit rock-bottom.

Thus, if you're willing to purchase Chinese stocks amid the recent fear-driven sell-off, Tencent's American depositary receipts look like quite a solid value today.