Attractive Relative Value in Chinese "BATJ" vs. U.S.-Based "FANG" Stocks

Consider the basic economic truth that faster GDP growth corresponds to higher revenue and earnings growth for companies, typically leading to higher stock returns over the long run.  With this principle in mind, let's take a look at the current market situation involving large-cap Internet stocks.

Due to governmental restrictions limiting access of companies seeking to do business in China, the global Internet economy naturally divides into two geographical regions:

• U.S.-based "global" Internet companies doing business everywhere except China:  Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Google/Alphabet (GOOG), comprising the four so-called "FANG" stocks, represent the ex-China Internet economy; and
• Chinese Internet companies doing business primarily in China:  Baidu (BIDU), Alibaba (BABA), Tencent (TCEHY) and JD.com (JD), being the so-called "BAT" stocks plus JD.com, represent the analogous China-centric "BATJ" foursome.

As is reasonably expected in China's developing economy (annual GDP growth = 6% to 7%) which is growing faster than the global economy (annual GDP growth = 3%), the Chinese "BATJ" Internet stocks exhibit both historical and forecast revenue growth rates that are higher than growth rates for their U.S.-based "FANG" counterparts:

• Between 2013 and 2015, the "BATJ" companies (revenue growth = 42% to 55%) showed average revenue growth about 20 percentage points higher than the "FANG" companies (revenue growth = 25% to 31%);
• For 2016, the average revenue growth figures are comparable;
• For 2017 and 2018 (based on analysts' consensus estimates), the "BATJ" companies (revenue growth = 27% to 37%) are again ahead of the "FANG" companies (revenue growth = 21% to 27%), now by 6 to 10 percentage points.

Contrary to expectation based on revenue growth, observe that over the past five years the Chinese "BATJ" stocks have actually underperformed the U.S.-based "FANG" stocks.  Between year-end 2012 and yesterday (May 2, 2017),

• $100 invested in an equally weighted (25% in each of four stocks) "FANG" portfolio, rebalanced annually, would have grown to $581, while
• the same amount of money ($100) similarly invested in the "BATJ" portfolio (with Alibaba and JD.com purchased at the end of 2014 following their IPOs) would have resulted in the lesser sum of $315.

Using analysts' consensus estimates of next year's (calendar year 2018) earnings per share and earnings growth, we can examine current market valuation by considering the PEG ratio (P/E divided by earnings growth rate).  The table and graph below show this PEG ratio for both "FANG" and "BATJ" stocks.  Observe how the "BATJ" stocks (average PEG = 0.76) are currently trading at a more attractive (less expensive) average PEG ratio than the "FANG" stocks (average PEG = 1.08).

The outperformance of the "FANG" stocks over the past four to five years is reflected in the richness of their PEG ratio relative to the "BATJ" stocks:

• (2013-2017YTD return of "FANG")/(2013-2017YTD return of "BATJ") = 581/315 = 1.84
• (2018 PEG of "FANG")/(2018 PEG of "BATJ") = 1.08/0.76 = 1.42.

In other words, if the Chinese "BATJ" stocks were to rise 42% relative to the U.S.-based "FANG" stocks, the Chinese and U.S.-based stock porfolios would show comparable valuation ratios.  Such a prospective rise of the value of the Chinese portolio would close much of the performance gap between the two portfolios that has accumulated over the past four to five years.

Therefore, a rational investor might expect, assuming all else equal,  to see general outperformance of Chinese Internet stocks relative to U.S.-based Internet stocks over the next few years.

(Disclosure:  Author currently manages portfolios long BIDU and BABA.)