Over the past two decades, many investors bought Chinese tech stocks because they seemed to offer more growth potential than their American counterparts. On the surface, the comparisons seemed simple.
Baidu (BIDU 2.30%), which owns China's largest search engine, is often compared to Alphabet's Google. Alibaba (BABA 2.33%), China's top e-commerce and cloud platform company, seems similar to Amazon.
But if we dig deeper, we'll spot significant differences between Chinese and American tech companies. Let's discuss six oft-overlooked facts investors should review before buying any Chinese tech stocks.
Image source: Getty Images.
1. Chinese tech stocks go from imitators to innovators
Many of China's largest tech companies started out by imitating overseas companies. Tencent's (TCEHY 5.23%) first major product in the late 1990s was QICQ, a clone of the popular messaging platform ICQ.
After being threatened with lawsuits, Tencent rebranded QICQ as QQ and expanded it into an online platform for social games, music, movies, shopping, microblogging, and group chats. QQ's growth paved the way for the launch of WeChat, the mobile messaging platform that now serves over 1.2 billion monthly active users.
WeChat now locks in users with millions of Mini Programs, which enable them to pay their bills, buy things, hail rides, play games, and more without ever leaving the app. That evolution, which can be spotted in many other Chinese tech companies, shows how the imitators evolved into innovators.
2. Chinese tech stocks tend to go public in the U.S. first
Many Chinese tech companies, including Baidu and Alibaba, went public in the U.S. long before they launched secondary listings in Hong Kong. They did this for two reasons.
First, Chinese exchanges had stricter listing requirements and longer waiting periods than U.S. exchanges. Second, the New York Stock Exchange and Nasdaq Stock Market gave them access to much more capital than domestic exchanges.
3. Many Chinese tech stocks have opaque ownership
China's government doesn't actually allow foreign investors to own stakes in its tech companies. But SINA, the first major Chinese tech company to go public in the U.S., circumvented the rule by creating the VIE (variable interest entity) structure, which creates a holding company in a third country like the Cayman Islands.
The VIE, which was still controlled by Chinese citizens, held shares of the underlying company in China. When SINA went public in New York in 2000, it only listed shares of the VIE -- which prevented foreign investors from ever taking control of the actual company.
Other companies bought smaller, publicly listed companies in the U.S. and went public through reverse mergers. That approach, which the SEC didn't aggressively monitor at the time, allowed many fraudulent companies with fake financials to slip onto U.S. exchanges.
4. U.S. investors can get hurt by go-private deals
Many Chinese companies that go public in the U.S. are still completely controlled by their founders through opaque ownership structures. As a result, these founders can abruptly take their companies private after raising funds on American exchanges, then relist them on Chinese exchanges to raise even more money in new IPOs.
Image source: Getty Images.
There's no way for American investors to block these deals, which often force them to sell their shares at steep losses. For example, SINA went private earlier this year after being acquired by New Wave Holdings, a company directly controlled by SINA's own CEO Charles Chao.
The $2.6 billion bid valued SINA at just over one times its annual revenue and assigned practically no value to its majority stake in Weibo (WB 2.40%) -- which currently has an enterprise value of $10 billion.
But that's just the tip of the iceberg. Many other Chinese tech companies went private in similar deals and left American investors holding the bag.
5. Chinese tech stocks face regulatory pressures from all sides
Many Chinese tech stocks underperformed the market this year for two reasons. First, they fell out of favor as concerns about inflation and rising bond yields sparked a rotation from growth to value stocks.
Second, regulators in both China and the U.S. are squeezing these top companies. China fined Alibaba a record $2.8 billion earlier this year after its antitrust probe, and slapped Tencent, Baidu, and other tech companies with additional fines over unapproved acquisitions. Chinese regulators are also constantly monitoring these tech platforms for "inappropriate" content.
Meanwhile, American regulators recently approved a law that will delist foreign companies from U.S. exchanges if they don't comply with tighter auditing standards within three years. They'll also need to prove they aren't being controlled by foreign governments -- which could be difficult as the Chinese government tightens its grip on the country's largest tech companies.
6. Despite issues, some Chinese tech stocks are still great bargains
After reading these five points, investors might shun all Chinese tech stocks. That might be a prudent move, but investors who can stomach the near-term volatility can still find some great bargains.
For example, JD.com (JD 5.80%), China's second-largest e-commerce company, is still firing on all cylinders -- yet its stock trades at just 28 times forward earnings and less than one times this year's sales.
Therefore, I don't think investors should completely avoid all Chinese tech stocks. However, I think they should carefully read the fine print instead of blindly chasing the sector's highest-growth names.
