• The London Financial

Golden Dragons: The Case for E-Commerce in China

Updated: Jul 19, 2020

The future of e-commerce looks bright. By the end of 2020 global e-commerce sales will account for 16% of total retail purchases. Accelerated as result of the ongoing health crisis, e-commerce is a growing trend that will stay with us after the pandemic has been resolved. Digital Commerce 360 reports that millennials currently make 60% of their purchases online, whilst Nasdaq claims that by 2040, 95%

of all purchases will be made via e-commerce.

For retailers, the brick-and-mortar model doesn’t always make financial sense anymore, as evidenced by Microsoft's decision to permanently close all its retail stores in June. The heavy overheads associated with brick-and-mortar retail can

often mean lower margins and less competitive prices. Secondly, one consumer trend that has continuously shaped our society is the tilt toward convenience, as seen in the proliferation of meal delivery services such as UberEats. The key difference being that meal delivery services have struggled to be profitable (UberEats loses $1.10 on every

delivery), whilst e-commerce is proving to be enormously profitable.

China’s e-commerce leader, Alibaba, is expected to generate 1.17 trillion dollars of retail e-commerce sales (gross merchandise volume) this year in mainland China alone. This is almost 3 times as much as Amazon’s expected total global sales of $416 billion. Alibaba (like Amazon) is also more than just a market leader in e-commerce, with profitable operations in cloud computing and digital media. Second place in China’s massive e-commerce market is JD, which has projected sales this year of $357 billion in China, approximately equal to the combined domestic sales of the top 5 e-commerce retailers in the US.

Amazon’s success has shown us that scale works in e-commerce. Bezos’ plan from the beginning was for aggressive growth to create economies of scale which translate to savings for the customer. These savings lead to more customers which lead to more economies of scale and so on. This model has created a moat in the form of economies of scale that competitors find hard to match. More scale leads to better margins and when it comes to scale, nowhere comes close to China.

The sheer size of China is almost difficult to fathom. At 1.45 billion people, its population is approximately the size of the US, Europe and South America combined. There are 288 million internet users in the US which equates to 87% of the population. China has more than 3 times as many at 904 million (63% of the population). China has plenty of room for growth in terms of its internet users, and with the growth of the country’s GDP-per-capita and average wages, it is reasonable to believe that internet users in China will increase considerably in the coming years. The 2020 China Internet Report, produced by SCMP Research, found that the global pandemic has had a profound impact on China’s technology landscape, rapidly accelerating the adoption of e-commerce. Chinese e-commerce retailers have also proven popular with consumers from Russia and other fast-developing Asian countries such as South Korea.

E-commerce has had greater retail market penetration in China than any other country, this year e-commerce will account for 41% of total retail sales. In the US, this figure is 14%. On Black Friday in 2019, US consumers spent $7.4 billion online across all e-commerce retailers, the biggest Black Friday ever for digital sales. During last month’s Chinese shopping event known as ‘618’, Alibaba alone recorded sales (GMV) across its multiple platforms of more than 13 times that figure ($98.5 billion) in just one day. Runner-up JD recorded $37.9 billion. On ‘Singles Day’ last year, Alibaba generated 1 billion dollars of sales in just 68 seconds. With numbers like these, Alibaba has significant upside potential in its earnings if improves its ability to monetise the astronomical amount of gross merchandise volume sales across its platforms.

Food and beverage, the largest retail category by a considerable margin, has not adopted e commerce to the extent of sectors such as consumer electronics, largely due to the perishable nature of food products and the unique storage and logistic requirements. Improvements in logistics and technology, as well as changing consumer behaviour are likely provide a strong tailwind for future growth in this sector. Grocery e-commerce has seen strong adoption growth in Britain, as seen in the rapid growth of Ocado, the British online supermarket that describes itself as 'the world's largest dedicated online grocery retailer'.

Demand for food e-commerce in the US is growing rapidly. Walmart, Costco and Target have all been stepping up their e-commerce offerings. Walmart just launched Walmart+ to challenge Amazon’s successful Prime subscription service. Both JD and Alibaba exhibit strong growth in their grocery e-commerce divisions. Their grocery sales are forecast to expand at a CAGR of 28% and 25% respectively. JD and Alibaba both offer excellent delivery services which are proving popular with consumers. In many areas in China, they offer delivery of groceries within 30 minutes.

From a fundamental perspective, if we compare the two e-commerce titans of their respective countries, Amazon is trading at a trailing PE ratio of 152 whist Alibaba is trading at 33. US company Shopify, the cloud-based multi channel commerce platform which helps small business sell directly to customers online, has seen over 160% growth in its share price since January and is yet to turn a profit. It is currently trading at a price-to-sales ratio of 68.9. Chinese e-commerce service provider, Baozun, often referred to as the ‘Shopify of China’, is trading at a price-to-sales of 2.5. Granted these ratios don’t paint the full picture, especially with growth companies; all 4 businesses have different growth strategies and different business models, however I do think the numbers (and the significant variances) are worth taking into consideration when forming a view on valuations.

The metrics on the right clearly show that the Chinese companies lead the way in terms of value metrics. With the the exception of JD, they also lead in terms of profitability. It is interesting to note that JD and Alibaba lead Amazon in terms of growth. I’m not presenting these numbers in a case of support for Alibaba/JD over Amazon, or Baozun over Shopify (I am currently long all 5). They are all brilliant companies with excellent growth potential, however I believe that for a global investor wanting e-commerce exposure in their portfolio, the value factors of the Chinese companies make a good case for inclusion.

All the companies display strong momentum, however, with the exception of the JD, the US stocks have exhibited considerably stronger price performance this year. I suspect that the amplified levels of price performance for the US stocks may be partly due to some irrational exuberance from investors and partly due to the ongoing US/China political tension, which has created concerns for investors. The Chinese stocks may well close the price-performance gap on their American counterparts in future, as a result of the significant disparity in their value factors.

The main force driving the global economy and its markets in 2020 is coronavirus. Current stats report 62 coronavirus cases per million people in China. Whilst cases may have been underreported in China, this figure is dwarfed by the 9507 per million reported in the US. It is unlikely that entirety of this difference is the result of Chinese propaganda. China’s strong-handed response has prioritised the long-term functioning of its economy, while the US has prioritised the short-term functioning of its financial markets. In objective terms, China’s response to the virus has been considerably more effective than that of the US, and, as a result, the scarring that the virus has caused may well prove to be considerably less significant in China than in the US. According to the IMF, the U.S. economy is expected to contract by 8% in 2020, whilst globally GDP is expected to contract by 4.9%. If you contrast that with the median forecast of 1.2% GDP growth for China reported by Bloomberg last week, the US and China are sitting at opposite ends of the distribution.

Before the pandemic, China’s GDP was widely expected to overtake the US by 2025. The impact of the pandemic and the resulting contraction of US GDP are likely to have accelerated this projection. China’s retail market ($5.07 trillion) will overtake the US ($4.89 trillion) for the first time in history this year. China’s response to the pandemic appears to have served its economy well, whilst the US response has been great for its financial markets. This has created a large divergence between the US economy and its financial markets. Historically, these divergences have reversed.

While political tensions between US and China present a relatively significant threat to export-heavy Chinese industries such as manufacturing, China’s leading e-commerce firms derive more than 90% of their revenue from within China. Investors concerned about US threats of delisting Chinese companies may prefer to buy HKX listed shares. Given that one of the main long term drivers of US corporate profitability has been globalisation, US policy makers may actually be less enthusiastic about a de-globalised economy and a full on trade war than they sometimes make out. There are admittedly political risks associated with Chinese investments. China’s new Hong Kong security law is a cause for concern. Heading in to an election, US investments, have their own political risks which are likely to increase market volatility in the coming months. If Biden is elected (which is looking increasingly likely) he is likely to raise corporate taxes which will impact profitability.

One of Warren Buffet’s favourite indicators is market cap to GDP, which he has described as "probably the best single measure of where valuations stand at any given moment." Currently the ratio of market cap of publicly traded companies headquartered in the US to GDP is 150%, which is the highest it has ever been. At the peak of the 2000 tech bubble it hit 139%. This bearish indicator may well explain why Buffet is currently sitting on so much cash. Warren isn’t alone, there’s nearly $5 trillion parked in money market funds, surpassing the peak of the financial crisis, with many cautious investors unwilling to put money into stocks given the current economic uncertainty. China’s market cap to GDP ratio hasn’t recovered since the highs (and subsequent crash) of 2007. It currently stands at 63%. Based on this metric it would be reasonable to assume that the US market is overbought and overvalued, whilst arguably China’s is oversold and undervalued. Over the long run, stock market valuations revert to their mean. Higher market valuation levels correlate with lower long-term returns whilst lower market valuation levels correlate with higher long-term returns.

Mebane Faber, co-founder and CIO of Cambria Investment Management, gave a talk at Google titled ‘Global Value: How to Spot Bubbles, Avoid Market Crashes and Earn Big Returns’. Mebane discussed the use of Schiller’s cyclically-adjusted price-to-earnings (CAPE) ratio as an indicator of a country’s value factor in a global investment strategy. While CAPE ratios aren’t always especially effective for market timing, they are powerful at forecasting long horizon returns. Historically, investing in countries with lower CAPE ratios has generated better returns over time. China’s CAPE ratio is currently 15.9 (almost half that of the US) which suggests that China’s value factor may merit inclusion in a global portfolio. Currently the US CAPE ratio is 28.8 (it has only ever been higher on 2 occasions: before the crashes of 1929 and 2000).

With US 10-year treasuries currently yielding 0.61%, and projected US inflation for 2020 at 0.62%, real treasury yields are effectively negative. With the Federal reserve saying they expect to keep the federal funds rate near zero through 2022, investors looking for returns are having to look outside of the federal fixed-income market. Credit spreads have increased and junk bond yields are high, but so is the rate of default and this might snowball if the pandemic continues to wreak havoc on the economy and impede debtors abilities to meet their debt obligations. Despite the economic uncertainty, for many investors equity markets appear to be offering better returns, even on a risk-adjusted basis. Rock bottom interest rates and unprecedented QE may well keep the US stock market bullish for a while longer, however US market valuations are reaching worrying levels and investors of the view that its equity markets are overstretched may soon consider looking for future returns outside of the US.

China’s unstoppable growth, scale and the attractive valuation of its equity markets relative to that of the US present a compelling option for global investors. Within China, e-commerce titans such as Alibaba and JD are leading the way in a changing society, and make a good case for inclusion in a forward-looking global portfolio. These firms have capitalised on, and will continue to profit from, permanent shifts in consumer trends which have been accelerated by the pandemic.

By Tom Banner - Incoming MSc Finance Student at Esade Business School. BCom Economics Graduate

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