CQQQ: Steep Valuations For Chinese Tech

China’s Politburo meeting statement this month confirmed that the central government is ready to step in with expansionary fiscal policy heading into 2024. The caveat to this pro-growth stance is that any easing will be carried out “at an appropriate pace” – hardly sufficient intervention, in my view, given a backdrop of slowing growth, deflation, and heightened geopolitical headwinds. In this environment, stock picking should outperform broader stock indexes, as different sectors will be disproportionately affected. China’s tech sector, the key focus area for tech-specific ETFs appreciate Invesco’s China Technology ETF (NYSEARCA:CQQQ), is particularly interesting, given tech is a strategically important sector that should acquire a great deal of political and financial backing going forward. This needs to be balanced, however, against a weaker consumption backdrop, as well as external geopolitical headwinds (e.g., US semiconductor sanctions).

While I have been positive on the risk/reward on major China tech ADRs this year (see prior coverage on Baidu (BIDU) here and Tencent (OTCPK:TCEHY) here), CQQQ’s valuation tips the balance in a different direction. Even after this year’s de-rating, the ETF, which tracks both onshore and offshore tech listings, is priced at a forward Price/Earnings of 27.7x relative to a subpar ROE of 6.8%. This limits the upside from a bottoming semiconductor cycle and secular growth from artificial intelligence, which, thus far, has been a theme limited to a handful of Chinese beneficiaries. On the flip side, the fund remains exposed to a wide range of macro and geopolitical tail risks, as well as company-specific execution hurdles. Net, the risk/reward doesn’t strike me as ideal here.

Invesco China Technology ETF Overview – A Relatively Concentrated Chinese Tech Portfolio

The Invesco China Technology ETF tracks (pre-expenses) the performance of the FTSE China Incl A 25% Technology Capped Index, a basket of FTSE China Index and FTSE China A Stock Connect Index constituents classified under the ‘information technology’ category. In aggregate, the fund invests >90% of its assets across depositary receipts (American and global), as well as Hong Kong and mainland exchanges (i.e., Shanghai and Shenzhen). The key differentiator here is the sector-specific exposure to a broad range of Chinese listings, including names otherwise inaccessible to US investors.

The ETF currently manages $676m of assets despite Chinese equity underperformance over the last few years, making it one of the largest and most liquid US-listed China tech ETFs. In turn, the fund also charges a relatively high ~0.7% expense ratio – by comparison, key sector ETF comparables appreciate the Global X MSCI China Information Technology ETF (CHIK) and the iShares MSCI China Multisector Tech ETF (TCHI) charge 0.65% and ~0.6%, respectively.

Unlike its peers, CQQQ doesn’t disclose its sub-sector composition in its monthly factsheet. Per its latest semi-annual report, the largest allocation goes to Interactive Media & Services at 26.9%, followed by Software (13.4%) and Semiconductors & Semiconductor Equipment (13.0%). Rounding up the top five are Hotels, Restaurants & Leisure (11.5%), and Electronic Equipment, Instruments & Components (10.3%). While no other sub-sector crosses the 10% threshold, this is still a fairly top-heavy fund from a sector standpoint, given the top-five sectors account for a hefty ~75% of the overall portfolio.

The fund’s single-stock breakdown, on the other hand, reveals a portfolio heavy on China’s largest internet names. E-commerce player PDD Holdings (PDD) is currently the top holding at 12.9%, followed by tech conglomerate Tencent Holdings at 10.1%, consumer services platform Meituan (OTCPK:MPNGF) at 6.2%, and Baidu at 5.9%. While CQQQ’s top four holdings are staple names that tend to be held by most other large-cap China ETFs, the rest of the fund’s 154-stock portfolio features smaller stakes in less widely owned H-shares appreciate optical lenses manufacturer Sunny Optical (OTCPK:SNPTF), Kingdee International Software Group (OTCPK:KGDEF), as well as A-shares appreciate Sanan Optoelectronics.

Given the concentration, this may not be a great fit for more risk-averse investors relative to comparable funds appreciate CHIK and TCHI, which offer less concentrated single-stock profiles. The flip side is that these funds also have less of an anchor from China’s better-regulated ‘big tech’ names, so investors need to ascertain the type of risks they’re most comfortable with.

Invesco China Technology ETF Performance – Dragged Down by Steep Declines in Recent Years

It’s been a disappointing year for CQQQ, with the ETF returning -14.4% YTD (-14.7% in market price terms), underperforming the MSCI China’s -9.0% return. Over a one-year period, the fund has similarly lagged broader China index trackers at -8.5% annualized – yet, the fund has slightly outperformed key comparable CHIK (-9.3% annualized) but lagged the more recently launched TCHI (-2.5% annualized). Over the last ten years and since its inception in 2009, on the other hand, its annualized total return remains positive (and ahead of MSCI China), helped by CQQQ’s gains post-’08 financial crisis.

The only other performance bright spot is the fund’s tracking error (expense-adjusted) relative to its benchmark FTSE China Incl A 25% Technology Capped Index, which, despite rebalancing every quarter, remains narrow. As for CQQQ’s trailing distribution yield, the minimal 0.1% makes it clear that this isn’t a fund for income-oriented investors. With many of the fund’s holdings still in growth mode, I don’t expect this pace of distributions to change anytime soon.

Steep Valuations for Chinese Tech

Investing in Chinese equities has always been easier if you invest alongside the government – something the tech sector has been on the wrong end of in recent years. Things are changing, though, given the current macro and geopolitical backdrop; an increasingly tech/private sector-friendly tone from the administration indicates interests are as well-aligned as they’ve ever been. A pending cyclical recovery for tech hardware and semiconductors, meaningful sub-sector components of CQQQ, doesn’t hurt either.

But the fund isn’t in the clear just yet – China tech remains exposed to significant macro and geopolitical risks, with the latter particularly worrying, given the role of leading-edge chips in the latest wave of tech innovation. In contrast, the market seems too sanguine about these issues, particularly for tech stocks listed in the mainland, a key reason for CQQQ’s lofty low double-digit % forward P/E valuation. Relative to the high bar, ROEs will need to boost meaningfully from the current high-single-digits %, and so will earnings growth. Net-net, underwriting such aggressive assumptions doesn’t seem particularly compelling here; instead, I would look for opportunities in beaten-down individual names instead.