Year-to-date, the U.S. stock market is up more than 22%. The Hong Kong stock market is down 8.91% during the same period. Why? Because China’s regulators crashed the stock market party. U.S. retail investors who parked money in Alibaba (BABA) or ETFs like the iShares China Large-Cap ETF (FXI) saw their account values crushed.
They forgot one critical component to international investing. Some countries come with more risk. Maybe you were aware of this concept but weren’t sure how to calculate the risk. I’ve got a step-by-step method to help you out.
Country Risk vs. Company Risk
Let me start by comparing the story of two Chinese companies. The first story starts back in 2019 — and it’s one I’ve told you about before. Luckin Coffee was one of the hottest stocks on the market. This tiny Chinese coffee chain blew up fast, overtaking Starbucks by opening 4,507 stores in just two years. In April 2020, it all came crashing down. Luckin admitted to fabricating $307 million in sales in 2019. Shares stopped trading around $25.50. It took several days before trading reopened around $2.50. In the months that followed, shares delisted, and they now trade in the OTC pink sheets market.
Our second story starts in July 2021. China’s government decided that online tutoring companies needed to transform into nonprofits. TAL Education (TAL) saw shares nosedive from $20 to less than $5.
Why do I bring up these two stories? Other than both coming out of China, they highlight the different risks associated with investing in foreign companies. What happened with Luckin Coffee isn’t unheard of. We experienced similar pains with Enron and Tyco back in the late ’90s. However, their problems were more company-specific, and auditing and oversight of Chinese companies aren’t as comprehensive as they are for U.S.-listed enterprises.
TAL Education highlights a more extreme issue that comes with investing in foreign companies. That company was hit by governmental regulations that fundamentally changed the country’s online tutoring industry. And it isn’t unheard of. We’ve seen actions from the Chinese government play out poorly with other companies, from Alibaba and Jack Ma’s failed Ant IPO to American companies like Las Vegas Sands (LVS), which is heavily invested in Macau.
Quantifying International Risk
We can boil risk down to three areas:
- Government regulation and intervention — How much control does the government have, and how likely is it to exert that control? How does it compare to the environment in the U.S.? Don’t forget, the U.S. government stepped in to save the automakers and banks back in 2008.
- Oversight and transparency — What do the regulating bodies do, and how does that compare to their counterparts in the U.S. and elsewhere? Some countries have different reporting standards than generally accepted accounting principles (GAAP).
- Monetary policy — How loose or tight is the country’s monetary policy? Changes in monetary policy can impact earnings through currency gains and losses.
Make Like-For-Like Comparisons
Before we perform our risk assessment, we need to first understand how to select appropriate comparisons. When we compare the health of iShares MSCI U.K. ETF (EWU) to the iShares U.S. Russell 2000 ETF (IWM) in our TradeSmith Finance model, it turns out the EWU ETF appears much healthier. That seems odd, given all the labor and energy challenges facing Downing Street. But the answer is quite simple.
Nearly all of the EWU comprises companies with a market cap of $13 billion or more. Less than 1% of the IWM is made up of large-cap businesses. To make an appropriate comparison, you need to align three elements:
- Company size — Revenue is the best point of comparison, but market capitalization also works.
- Industry — Try to find as similar a business as possible when making comparisons. Baidu and Google may not be exact matches, but they are close enough.
- Growth — Ideally, you want to find companies with similar sales growth trajectories.
Keep in mind you don’t need to be exact on these. In some cases you may not be able to match all three. Now that we understand how to perform the analysis, let’s walk through the steps.
A Two-Step Process
Once we determine that a country carries more risk than the U.S., we want to add a discount to any stocks we purchase from that country. We start by comparing valuation metrics like price-to-earnings (P/E) or price-to-sales (P/S) ratios on two similar companies.
For example, investors often compare Baidu (BIDU), a Chinese tech company specializing in internet services and products, with Google (GOOGL). Based on P/E ratios, Baidu currently trades at 8.24x its earnings over the last 12 months, while Google trades at 28.51x its earnings over the same period. So, if all else is considered equal, we can say that the market assumes that the risk associated with Chinese stocks is 1 – 8.24 / 28.51 = ~71%. Back in 2018, Baidu traded at a P/E ratio of 30x, while Google traded 36x. So, even just three years ago, investors placed the risk of investing in Chinese stocks at 1 – 30 / 36 = ~17%.
The second step is to do a market comparison. We perform the same price-to-earnings and price-to-sales calculations to get a market average. Then we can see if the discount on individual stocks is bigger or smaller than the market average. For example (and we’ll explore further below), the KraneShares CSI China Internet ETF (KWEB) aligns well with the Nasdaq 100-focused Invesco QQQ ETF. You could also use the SPDR Tech Sector ETF (XLK) as well.
A Practical Example
Let’s say I’m considering an investment in NIO (NIO), the Chinese electric vehicle maker. TradeSmith Finance puts the stock’s health in the Green Zone. Plus, despite the heavy regulation from China’s government, I expect them to leave NIO alone. However, the Hang Seng Index is in the Red Zone. How do I know if I’m overpaying for NIO?
Let’s start by selecting a similar company. We’ll go with Tesla (TSLA) for ease at the moment. Unfortunately, NIO doesn’t have any earnings. So, we’ll look at the price-to-sales ratio compared to Tesla’s. NIO’s price-to-sales ratio stands at 13.9x, while Tesla’s comes in at 24.28x. That means NIO trades at a 43% discount. Now, I want to run the same exercise on similar market ETFs. The KWEB Chinese tech ETF and the Nasdaq 100 QQQ tech ETF will do nicely. We can add in the P/E ratios for additional data.
- P/E ratios: KWEB = 14.74x, QQQ = 31.9x, ~54% discount
- P/S ratios: KWEB = 3.07x, QQQ = 5.39x, ~43% discount
Our ETF comparison gives us a range of 43% to 54%. So, NIO is fairly priced based on this analysis.
Why This Is Important Now
I’m not a fan of the Chinese market right now. There may be opportunity there, but the timing on many of the stocks isn’t right. If you see opportunities in the Chinese market, I’d recommend you put your favorite companies, like Alibaba and NIO, on a TradeSmith Finance watchlist and wait for the technical indicators to turn. As they do come up, I can use the steps above to ensure that I don’t overpay for my investment.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
www.nasdaq.com