The Motley Fool

As China Tech Slows Down, What Should Investors Do?

As venture capital funding slows in mainland China, tech companies are rushing to go public in Hong Kong before public investor sentiment cools. Yet many of these IPOs have performed poorly. Read more about what’s going on and what investors should do.

VC funding in China is drying up

Chinese VC deals fell from over 1,200 in 2Q 2018 to just 713 in 4Q 2018. Venture capitalists, after seeing years of fast internet growth, are becoming less interested in China’s cash-burning start-ups.

Up until now, Chinese tech companies have focused on scaling their user bases first and monetizing later. This makes sense, because the market in China is so large, and most business models can be copied with few barriers to entry.

Scaling quickly to gain an economies-of-scale advantage makes sense, because companies that succeed will be able to price out smaller competitors. Examples include Didi vs Uber China (ride-hailing), Meituan (SEHK: 3690) vs Nuomi (group-buying), etc. Uber China was losing as much as ~$1 billion a year before retreating from the market in 2016.

Since VC funding is drying up and funds are no longer willing to foot the bill for fast growth, Chinese tech companies are looking to public markets instead. Companies such as Xiaomi (SEHK: 1810) and Meituan have been some of the few to list in 2018. And rumor has it that Didi, Ant Financial, Kuaishou, and Toutiao may look to list this year.

Recent tech IPOs have been disappointing

And yet recent tech IPOs have been disappointing. Shares of movie-streaming company iQiyi (NASDAQ: IQ), electric car maker NIO (NYSE: NIO), social commerce platform Pinduoduo, and Tencent Music Entertainment Group saw shares fall by an average of 13.1% in 2018, compared to a loss of just 0.77% for US IPOs over the same time frame.

What’s going on?

In addition to a slowing domestic economy, the internet industry is saturated, and user growth is slowing down – 757.2 million people are already mobile internet users in China, compared to ~300 million in the US.

Rather than targeting new internet users, Chinese tech companies will now have to fight each other for existing users, pushing up user acquisition costs. Consumer internet businesses such as iQiyi and Tencent Music focus on subsidizing users as they scale, but given the weakening environment, their ability to buy loyal users will be weakened going forward.

What should investors do?

Investors should avoid the consumer internet companies that have recently went public. Many of these companies had trouble raising funds on the private market, and may be looking to take advantage of naïve public market investors. After all, their bankers are incentivized to obtain the highest price for their IPOs.

Typical scale-first, profit-later consumer internet businesses like Meituan, which subsidize new users, are likely to see serious consolidation in the coming years. Investors should steer clear of these types of businesses, and focus on higher-profit businesses that can fund their own growth going forward, because the hype for internet companies may decline over the next two years.

Attractive sectors include fintech, education, and health care. For these businesses, the average value per customer transaction is much higher, but they scale at a slower rate, given that it’s harder to convince customers to part with larger amounts of money. The downside is that these companies may need to build out large sales organizations, which can take a long time.

On the positive side, these sectors are not winner-take-all industries. While Baidu may dominate internet search and Tencent and NetEase control ~70% of the mobile gaming market in China, industries such as fintech and education are much more fragmented. This leaves more room for smaller competitors to survive in China’s slowing economy.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Ker Zheng doesn't own any shares mentioned above.