A wonderful weekend to you as stocks took a breather from a tumultuous week and headed down into the weekend.
In brief (TL:DR)
- U.S. stocks flailed on Friday, with the Dow Jones Industrial Average (-0.42%), S&P 500 (-0.54%) and tech-centric Nasdaq Composite (-0.71%) all lower on concerns that China's crackdown on tech businesses and lofty expectations for corporate earnings may be disappointed.
- Asian stocks closed weaker on Friday weighed down by sentiment on Wall Street and concerns that the Chinese crackdown on tech stocks and earnings may miss estimates.
- Benchmark U.S. 10-year Treasuries slid lower 1.228% (yields fall when bond prices rise) as investors are now concerned that the bull run in equities may soon be drawing to a close.
- The dollar held gains.
- Oil inched higher with September 2021 contracts for WTI Crude Oil (Nymex) (+0.45%) at US$73.95 despite concerns that the delta variant could derail the economic recovery, with tight global supplies keep prices firm.
- Gold slipped with December 2021 contracts for Gold (Comex) (-1.01%) at US$1,8317.20 as inflation fears were put on the backburner.
- Bitcoin (+4.24%) surged into the weekend, clearing US$42,000 on Saturday with outflows leading inflows (outflows suggest that investors are looking to hold Bitcoin in anticipation of higher prices).
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In today's issue...
- China Stocks Soak More Blows
- Are Chinese Hot Pot Stocks Immune from Hot Soup?
- MicroStrategy's Bitcoin Paper Gains
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Market Overview
While there's seldom a good time for a Communist government to meddle in the markets, this would perhaps be the worst sentiment wise.
Global investors were already somewhat skeptical over how long the bull run in equities could continue.
But with a resurgent delta variant of the coronavirus, Beijing blasting its own listed companies overseas, increasing geopolitical tensions at a time when the U.S. Federal Reserve is considering tapering its asset purchases, is it any wonder then that investors are looking to vote with their feet?
Treasuries surged higher, while global investors dumped everything even remotely associated with China, with some naysayers using the opportunity to buy on the cheap.
Whether or not Beijing received the message that markets are easily spooked is less clear as it shows no signs of backing down on its crackdown of myriad companies, with speculation high that the wildly speculative and highly profitable real estate industry is next.
Asian markets were understandably worst for the wear into the weekend with Sydney’s ASX 200 (-0.33%), Tokyo's Nikkei 225 (-1.80%), Hong Kong's Hang Seng (-1.35%) and Seoul's Kospi Index (-1.24%) all down sharply.
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1. China Stocks Soak More Blows
- U.S. Securities and Exchange Commission requires higher levels of disclosure for Chinese firms listed on American exchanges including Chinese government connections
- Prospect of many Chinese firms headed back to Hong Kong or Chinese exchanges looms as geopolitical tensions between Washington and Beijing escalate
Just when you thought it was safe to wade into Chinese stocks again, the U.S. Securities and Exchange Commission steps in.
In a week which saw an estimated US$150 billion in market cap wiped off Chinese stocks and where Beijing, perhaps surprised by the strength of the backlash in response to its crackdown on for-profit afterschool education companies, had to reassure the market that the purge was limited to a single sector, things are not getting better.
Since the Trump administration, American regulators had been pushing for Chinese companies listed on American stock exchanges to deliver higher levels of transparency in their regulatory disclosures.
And as far back as 2006, it wasn’t uncommon for Chinese companies to gain access to American capital markets through reverse takeovers of listed vehicles and then fudging books and numbers, to predictably disastrous consequences.
But growing Sino-American tensions have led to increasing levels of distrust in both capitals and SEC Chairman Gary Gensler is now seeking greater disclosures from Chinese companies listed in the U.S., including the disclosure of their structure and contacts with the Chinese government.
The SEC’s new rules were triggered in response by an announcement earlier this month that Beijing would tighten restrictions on overseas listing, with companies seeking such avenues for capital raising needing to receive regulatory approval.
Global investors dumped Chinese shares indiscriminately in response, with shares of Chinese companies listed on U.S. bourses tumbling by as much as 50% in recent weeks, despite recovering slightly towards the end of last week.
The bigger problem however is the longer-term damage that may already been done.
For decades, global investors have felt comfortable investing in Chinese firms listed in the U.S. as American Depository Receipts, negotiable securities of foreign companies listed on American exchanges, comforted by the supposed higher level of regulatory disclosures, protections and liquidity that the American capital markets provided.
And until fairly recently, global investor access to China’s stock markets had been limited.
What may be happening now is evidence of de-coupling, with China looking to develop and forge its own brand of capital markets, while it continues to compete with the U.S. on other fronts.
In the meantime though, the plucky investor could consider picking up Chinese shares battered by the recent turmoil on the cheap, knowing that companies like Alibaba (-1.19%) and Tencent (-2.64%) aren’t likely to disappear, and if they were to be de-listed in the U.S., find a safe haven in Hong Kong.
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2. Are Chinese Hot Pot Stocks Immune from Hot Soup?
Ultimately everyone needs to eat, don’t they? And for over a billion Chinese, more often than not it’s hot pot on the menu.
But amidst the recent crackdown in Chinese companies from Beijing and now Washington, global investors dumped stock of some of the biggest names in Chinese business almost indiscriminately, with some of China’s biggest tech companies down over 10% in July alone.
And the purge hasn’t just been limited to the Chinese afterschool education market, spilling over into even Chinese hot pot stocks, including Haidilao International Holding (-5.19%), Jiumaojiu International Holdings (-5.32%) and Xiabuxiabu Catering Management Co. (-1.84%).
Shares of the biggest hot pot chain, Haidilao, are now down 28% over the past month.
To be sure, Haidilao and other hot pot restaurants would understandably do badly in a pandemic landscape, where diners gather close together, dipping raw food and sharing in the same boiling pot of broth.
Coupled with the rising cost of raw ingredients, with the price of pork, a favorite dish in hot pot rising, against a backdrop of fewer diners and increased disinfection costs, companies like Haidilao were hammered, reporting an 87% decline in profit for the year, while operating margins which were unusually high for the sector in any event, were halved to 4%.
But somehow, shares of Haidilao only started tanking this year and not during the height of the pandemic’s lockdowns, and are now trading at an enterprise value to forward sales ratio of just three times, the lowest since the company was listed in 2018, even as demand is on the rise.
China, which has more or less opened up, despite sporadic outbreaks from the more virulent delta variant, has seen a surge in demand for gatherings, and Haidilao and the hot pot restaurants have been doing a brisk business.
Table turnover at Haidilao has recovered to over 75% of pre-pandemic levels while full year sales increased 8% from last year, albeit from a lower base, but there is room for further growth.
Average spending per guest has been rising as dining out is more of a special event, helping margins, although that has been undercut somewhat by rising costs.
And companies like Haidilao also demonstrated their resilience during the pandemic, with the hot pot leader increasing its delivery business by 60%.
Yet given how fragmented China’s hot pot business is, even though Haidilao is the biggest chain, it only accounts for less than 3% of the overall market, with plenty of room for expansion.
And that’s an important factor not just for the growth prospects of the company, but in terms of whether the sector is susceptible to regulatory backlash.
As industries grow, feeding the country seems not just uncontroversial, but perhaps even virtuous.
And Haidilao’s compensation model, which allows even a waiter to rise up the ranks to “own” their own branches provides for the inclusive capitalist (albeit with Chinese characteristics) model that Beijing would be keen to promote.
In China, provided that a server works hard, they can rise their way up the ranks to manage a whole restaurant, taking a share of the profits as well and that concept of social mobility, would speak well to Chinese Communist Party apparatchiks.
With tech and now even afterschool education companies coming under fire, global investors looking to still participate in the Chinese economic growth story could consider a defensive rotation into these hot pot companies, even though they're barely simmering at the moment.
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3. MicroStrategy's Bitcoin Paper Gains
- MicroStrategy (+0.16%) sits on US$1.4 billion worth of paper profits from its Bitcoin holdings
- Impairment losses have crept up however, especially given the volatility of Bitcoin
Until fairly recently, the only way institutional investors could gain access to Bitcoin was to purchase Grayscale Bitcoin Trust product, which came with lock-ins and a whole bunch of other restrictions that led to the growth of the “Grayscale Premium” – the difference between what Bitcoin cost as an underlying asset, and how much investors were willing to pay for it in an institutional wrapper.
But short of a U.S. Bitcoin ETF, investors had few choices for exposure to Bitcoin in the U.S., that is until MicroStrategy came along.
Ostensibly, MicroStrategy is an enterprise software company, but it’s big bets on Bitcoin have dramatically changed the complexion of the firm.
Yet investors looking to take a bet on Bitcoin who are buying MicroStrategy have to also note that by some estimates, just 23 cents out of every dollar in MicroStrategy’s share represents a direct exposure to Bitcoin.
That bet however has paid off in spades, with MicroStrategy sitting on massive paper gains from its bet on Bitcoin, despite having to write off millions in accounting charges at the same time.
With 105,085 Bitcoin, and based on yesterday’s prices, MicroStrategy is sitting on paper profits of US$1.4 billion – but that assumes you can sell 105,085 Bitcoin at one go without crashing the market – a big assumption.
Nonetheless, MicroStrategy’s second quarter earnings reveal that its paper gains on its Bitcoin bet is over double what the enterprise software firm has posted in cumulative earnings in the last 25 years according to data compiled by Bloomberg.
MicroStrategy’s nominal gain in its Bitcoin holdings is also over three times the revenue generated by the company since it adopted Bitcoin as its primary treasury asset last August.
According to one report, MicroStrategy holds approximately 105,085 Bitcoin as of June 30, with an average cost of US$26,080 and the company has plans for doubling down and going all in on its digital asset strategy.
But MicroStrategy’s Bitcoin holdings aren’t free, with cumulative impairment losses of US$689.6 million also associated with its cryptocurrency bet.
Impairment losses occur as the result of unusual or one-time events, that seriously damage the price of an asset and impairment exists when an asset’s fair value is less than its carrying value on the balance sheet.
Because Bitcoin is particularly volatile, a good accounting practice would be to test if it’s impaired and an impairment loss recorded, if testing reveals that such impairment exists.
An impairment loss records an expense in the current period which appears on the income statement and simultaneously reduces the value of the impaired asset on the balance sheet.
For investors who are long-only Bitcoin, then these impairments on MicroStrategy’s balance sheet are nothing to be overly concerned about.
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