While China investors have to contend with geopolitical tensions, the regulatory crackdown of 2021 and COVID lockdowns of 2022 have caused many high-quality Chinese stocks to trade at very, very low valuations. And they are especially cheap compared with U.S. tech stocks after the latter's big run this year.
Tencent (TCEHY 2.19%) could be the best company in all of China, but it also has fallen mightily from its highs as the Chinese government cracked down on big tech and gaming companies.
Last Friday, the stock plunged another 10% as China released a new spate of regulations that could curb the revenue of gaming companies.
However, for those looking for global stocks to buy this holiday season, I think the fear-driven sell-off is overdone and could be an opportunity for those looking to diversify into bargain-priced international stocks.
The new regulations
On Friday, Chinese authorities surprised markets, announcing a raft of new rules on video game play. Unlike a lot of Western markets, much of the Chinese video game market consists of free-to-play games, in which consumers pay for extra digital cosmetic features, achievements, advertising, and other elements within the context of the game.
According to the new rules, gaming companies will now be banned from offering digital rewards for certain behaviors, such as logging in every day, spending money on a game for the first time, or spending money on a game several times consecutively. Other new rules also prohibit activities such as auctioning off digital items or offering "lucky draw" features to minors.
Certainly, these rules seem like they would affect all free-to-play game revenue. And the new regulations came as somewhat of a surprise since investors had perhaps expected video game regulations were finished after a raft of 2021 rules to limit the play of minors.
At that time, regulators also suspended the approval of new games for almost a year. And they tightly restricted play for those under 18, who are now only allowed an hour of play during Friday, Saturday, or Sunday.
So, it's no wonder that Chinese video game stocks fell on the latest news. But is the fear justified?
The rules might not be a bad thing in the long run
A lot of the new rules appear to be fairly practical and aimed at some of the more egregious practices that can lead to addictive behavior and low-quality revenue from those who can't afford it.
Moreover, in conjunction with the new restrictions, Chinese regulators actually approved 40 new games on Friday, and then another 105 on Monday. Furthermore, one of the new rules is that regulators have to approve new games within 60 days of submission.
Lastly, there is a comment period until late January for industry participants to make their arguments on the new draft rules.
These measures seem to be part of an effort to let the industry know regulators aren't out to actively harm the industry, but rather to promote competition and more-responsible play.
China has definitely seen its economy weaken in the wake of its harsher 2021 crackdown, and it appears eager to get its economic engine going again.
That seems to be part of the reason President Xi Jinping came to San Francisco earlier this year to meet with President Biden and other leading business executives, to lure them back to investing in China again. So it doesn't appear China would be eager to weaken another of its key domestic industries.
Image source: Getty Images.
The impact should be minimal for Tencent's gaming business
Tencent, while known as a gaming juggernaut, isn't wholly dependent on its domestic games business. Last quarter, its domestic games business brought in 32.7 billion yuan ($4.58 billion) in revenue, up 5% from the prior-year quarter. But that accounted for only 21% of its overall revenue.
Tencent has a very balanced portfolio of streaming subscriptions, domestic games, international games, online advertising, traditional and social media, fintech, and cloud computing services.
Moreover, the domestic games portfolio didn't have a huge decline even after the harsh 2021 regulations took effect, basically taking away almost all of Tencent's revenue from minors and teens.
In the third quarter of 2022, domestic games revenue fell just 7% from the prior year, even as the full impact of the new regulations was felt, before bouncing back to 5% growth this year. The recent third quarter's $4.58 billion in domestic games revenue is almost back to the 2021 quarterly high of $4.71 billion.
So, the fact that Tencent only gets 21% of revenue from domestic games, and that this segment appears to have been relatively resilient even in the face of draconian gaming restrictions, means it's probably not much to worry about, and that Friday's drop is probably an opportunity.
Tencent is cheap
This year, Tencent rightsized its business in the face of steadier but lower growth. Last quarter, revenue recovered, rising 10%, but management's prudent cost controls allowed gross profit to grow 23% higher and operating profit to grow a whopping 36%.
Tencent only trades around 13.4 times earnings today, despite recent double-digit growth and a large investment portfolio. As of Sept. 30, its investments in listed and unlisted companies totaled over $113 billion -- almost a third of Tencent's $356 billion market cap today!
That means when stripping out investments in other companies, Tencent trades around only 8.5 times earnings! Given its dominant leading position across games, social media (WeChat), cloud computing, and digital payments, that seems way too cheap.
That makes the fear-driven sell-off an opportunity, at least for those who feel comfortable investing in China, as well as for those looking for cheaper alternatives to U.S. tech stocks that have run up so much this year.
