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Why Tech Stocks Could Rebound After a Brutal 2018

The tech industry went through a difficult year in 2018, hurt by fears of a US-China trade war and worsening macroeconomic conditions. But in 2019, the tech sector has rebounded on government pledges to stimulate the economy.

Why and how the government stepped in

In October 2018, rumors emerged that the US was pressuring other countries to stop using Huawei’s 5G telecom equipment. Over 1,000 stocks on the Shanghai and Shenzhen stock exchanges froze trading as they dropped by their daily maximum limit of 10%.

But in January, the government announced that it will increase fiscal expenditures and implement larger tax and fee cuts, with a focus on reducing burdens for small firms and manufacturers. Last year the government had reduced the amount of reserves banks are required to hold, in an effort to encourage more lending.

Tax cuts may be the key to unleashing more of China’s potential. After all, Chinese companies, through value-added taxes and income taxes, contribute over 60% of the Chinese government’s tax revenues. Cutting some of their taxes may open up more of their budget to invest in their businesses and hire more employees, a potential boon for consumer spending and tech companies that depend on it.

Most Chinese Tech Stocks Not Directly Affected by US-China Trade War

Much of the volatile market sentiment regarding China stocks owed to the US-China trade war, since hardware makers such as Huawei and ZTE depend on American suppliers for key parts such as semiconductor chips. But I think these worries are unwarranted, because most tech companies in China derive the majority of their revenues from domestic demand.

For example, e-commerce companies such as Alibaba(NYSE: BABA) or JD.com (NASDAQ: JD) may source some of their products from the US, but the US government is unlikely to crack down on their own exports for fear of harming the US economy. What’s more, the vast majority of Alibaba’s and JD.com’s revenues come from selling to Chinese consumers. These stocks all declined heavily in 2018, and while they’ve recovered slightly since then, they’re still a bargain when compared to their US counterparts.

Companies like Baidu(NASDAQ: BIDU) and Tencent(SEHK:0700) also derive most of their revenues from domestic Chinese demand. Baidu’s core search advertising business and Tencent’s gaming business are relatively unaffected by the US-China trade war. Yet both of these stocks have fallen precipitously over the last year or so, creating an opportunity for investors.

What Investors Should Do

Investors should look toward larger Chinese tech companies that have mature, profitable business models and derive their revenues from Chinese consumers. These companies have advantages in their large pools of consumer data. Those with more data can train AI-enhanced algorithms to better monetize user traffic and provide better returns on ad spending for third-party partners such as consumer brands.

For example, Baidu has large amounts of search data, which it can use to better understand what its users are looking for. And it can leverage that knowledge to deliver those users precisely targeted advertising. Alibaba does the same for e-commerce searches, giving brands who want to advertise on its platforms better value for their money.

Smaller, less mature tech companies lack this advantage. They’re still in the process of building their business models and scaling their user bases. And these days it’s hard to grow that kind of audience – after all, most people in China already have smartphones and are spending over three hours a day on them. When you account for the amount of time spent at work, cooking and eating, or socializing with friends and family, there’s only so much time in a day. Going forward internet companies will likely be fighting for existing users’ attention, rather than seeking out new users.

So while there will be opportunities in the Chinese tech sector to come, investors should be wary, and pick their stocks carefully.

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Disclosure: Motley Fool Hong Kong is not licensed by the Hong Kong Securities and Futures Commission to carry out any regulated activities under the Securities and Futures Ordinance. Ker Zheng doesn't own any shares mentioned.