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Read This Before Buying Chinese Tech Stocks

Leo Sun, The Motley Fool

Many Chinese tech stocks generated triple-digit gains over the past few years, and top performers like Baidu (NASDAQ: BIDU), Alibaba (NYSE: BABA), and Tencent (NASDAQOTH: TCEHY) continue to impress investors.

Growth investors love Chinese tech stocks since China's economy could eclipse the American economy by 2030 according to the Center for Economics and Business Research (CEBR) in London. But the Chinese tech industry is still a risky one that could punish careless investors.

A Chinese flag key situated next to an "internet" key.

Image source: Getty Images.

Today we'll take a balanced look at the Chinese tech market and identify the main trends investors should be aware of.

Recognizing the biggest players

Baidu, Alibaba, and Tencent -- commonly called the "BAT" triumvirate -- dominate the Chinese tech landscape with their massive ecosystems.

Baidu controls over 70% of the country's online search market, Alibaba's Tmall controls over half of the e-commerce market, and Tencent dominates the social networking and gaming industries with WeChat, the most popular messaging app in China, and blockbuster games like Honor of Kings, League of Legends, and Clash of Clans.

The BAT companies are all expanding their ecosystems into adjacent markets to lock in users. Key growth markets include mobile payments, fintech, artificial intelligence, and online-to-offline (O2O) services like ride hailing apps, online travel services, food deliveries, and streamlined e-commerce purchases.

But as intense as these battles are, the BAT companies' growth rates all indicate that there's still plenty of room for all three companies to thrive.

Company

Current Fiscal Year Estimated Sales Growth

Current Fiscal Year Estimated Earnings Growth

Baidu

20%

59%

Alibaba

55%

45%

Tencent

32%

33%

Source: Yahoo Finance.

Understanding the overlapping alliances

A recurring theme in the battle between the BAT companies is the use of cross-industry partnerships and acquisitions to expand the companies' ecosystems.

JD.com, China's second largest e-commerce player after Alibaba, recently struck data-sharing and streamlined checkout partnerships with Baidu, Tencent, Wal-Mart, and flash sale site Vipshop to widen its moat against Alibaba's Tmall.

In 2014, Alibaba acquired UCWeb, China's top mobile web browser maker, and its subsequent investments in UCWeb's Shenma search engine gave it a 15% share of China's online search market, making it a thorn in Baidu's side. Alibaba is also the second-largest stakeholder in microblogging site Weibo, which gives it a foothold in the social networking market against Tencent.

Meanwhile, Tencent transformed WeChat into a monolithic "super app" for various search, O2O, and e-commerce services, which irritated both Baidu and Alibaba. Last quarter, Tencent reported that WeChat's global monthly active users (MAUs) rose 16% annually to 980 million -- which gives it a massive launchpad for new services.

WeChat's iOS app.

WeChat's iOS app. Image source: iTunes.

But be wary of smaller and less diversified players...

Baidu, Alibaba, and Tencent are arguably the safest Chinese tech stocks for conservative investors. However, the market is still filled with less reputable companies or ones with poorly diversified business models.

For example, Chinese peer-to-peer lender Yirendai (NYSE: YRD) might initially seem like an undervalued growth stock. Analysts expect its revenue and earnings to respectively rise 74% and 14% this year, yet the stock trades at just 9 times forward earnings.

But here's the catch: the vast majority of Yirendai's loans are "deep subprime" loans, the company doesn't disclose its delinquency rates for loans past due by more than 90 days, and troubling reports indicate that the company is actually a "dumping ground" for its parent company CreditEase's worst loans.

Two other high-growth darlings, YY (NASDAQ: YY) and Momo (NASDAQ: MOMO), both saw explosive gains over the past year on the strength of their live video streaming businesses.

However, their growth relies on a small percentage of users subscribing or buying virtual gifts for their favorite broadcasters, and Chinese regulators have been aggressively cracking down on live streaming platforms -- claiming that they "harm social morality." This means that YY and Momo's gains could abruptly evaporate with little warning.

Don't underestimate the wrath of Chinese regulators

Lastly, investors in Chinese tech companies should never underestimate the government's ability to throttle their growth. After regulators forced Baidu to remove "misleading" ads during fiscal 2016, the company posted just 6% revenue growth that year (12% excluding the Qunar share swap), compared to 35% growth in 2015.

The Chinese government also fined Baidu, Tencent, and Weibo last year on vague allegations that they didn't properly monitor and censor their own content. These regulations and fines represent unpredictable headwinds that could abruptly reduce growth forecasts in an otherwise strong year.

The key takeaway

I'm bullish on Chinese tech stocks, and I personally own shares of Baidu and Tencent. But this industry isn't for queasy investors, and you should always do your due diligence before diving into this high-risk market even if it offers potentially high rewards.

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Leo Sun owns shares of Baidu and Tencent Holdings. The Motley Fool owns shares of and recommends Baidu, JD.com, and Tencent Holdings. The Motley Fool recommends Momo and Weibo. The Motley Fool has a disclosure policy.