Something freakish took place in China ADRs last week. Almost every once-beloved American Depositary Receipt seemed to be infected with a panic-selling “virus”.

Over just two days, Alibaba Group Holding’s stock price dropped 14%, Meituan -20%, JD.com -23%, PinDuoDuo (PDD) -26%, and Didi Global -50%. The indiscriminate selling was not limited to just a handful of stocks, as the KraneShares CSI China Internet ETF — which tracks the CSI Overseas China Internet Index — dropped 19% over two days.

This bizarre behaviour of the sellers had not been seen in the past. There wasn’t any earth-shattering event last week that could be pinned down to explain the frenzied panic selling. The most common explanation we heard from market participants was the US Securities and Exchange Commission singling out five ADRs for failing to submit their auditor notes.

We find this explanation inadequate because this eventuality has long been foreshadowed and therefore could not have been the major cause. One probably should not make a mountain out of a molehill over price changes spread across a mere two days. But from the peak in February 2021, the CSI Overseas China Internet Index is down a whopping 75%.

Such dramatic market behaviour over a year cannot be just called a bear market; it is more apt to call it a super-bear market.

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This article will attempt to shed some light on China ADRs, which must not be extended to apply to all China stocks listed in China and Hong Kong, for the circumstances — including the investors in both genres of stocks — are rather different. The tide of liquidity seemed to have flowed out from China ADRs at such pace and magnitude that even investors in a low crouch are caught naked, much less those standing tall and proud.

Keep in mind that the majority shareholders of China ADRs are American institutional and retail investors as well as mutual funds. Why have American investors turned so bearish on them? Super-bull market Investors have offered various reasons for the superbull market in China ADRs.

One should not tar the China ADRs with a broad brush as they operate in different industries. Alibaba, JD and PDD are the three e-commerce superstars, although there are thousands in this space. They have been on the buy list of most sell-side analysts and are also held by most institutional portfolios and mutual funds.

The trio had a combined market cap in excess of US$1.2 trillion ($1.6 trillion) at one time. As of last Friday, and within a year, investors gave them a collective valuation of just US$350 billion.

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One good story cited again and again was the size of the Chinese online market — the largest in the world. The favourite valuation metric used was price-to-GMV (gross merchandise value) ratio, which many argued was low. PDD was valued at US$250 billion just a year ago, a mere six years after its founding. It is a company still struggling to make its first profit. Meanwhile, the founder at 43 years of age retired as chairman and CEO a year ago. The company raised US$4.12 billion just 16 months ago, at a price about four times higher than last Friday’s closing price.

What was extraordinary about this particular capital raise was that a US investor, not having enough of it, asked for an additional US$500 million days after books closed. The company delightfully obliged.

JD, founded 19 years ago, has captured the imagination of the majority of investors since its IPO eight years ago. It is probably still heavily favoured by the investment community. Since its IPO, its management has repeatedly said in its quarterly earnings calls they are investing for future profitability and cash flows, and that investors would not have to wait for more than 2-3 years before seeing strong cash flows and profits. It has cited investments in drones, in cloud computing, in building a million convenience stores, and so forth.

It is inexplicable why US investors had been so forgiving despite repeated earnings disappointments and poor or no follow-through in execution after grandiose announcements. Meanwhile, the rising stock price gratified US investors.

Last week, its new CEO urged investors to look beyond short-term results after the company reported dismal fourth-quarter and full-year results. This time, investors dumped the stock — its share price plummeted 23% over two days.

The principal reason for the super-bull market in China ADRs is, in my opinion, Wall Street liquidity. This liquidity was chasing quick returns. Fast action rather than careful and rigorous research was the new recipe for instant success. Warnings about dubious or profitless business models, mediocre and reckless management, weak financials and so on were considered by the bulls as bears’ sour grapes and hence fell on deaf ears.

Benjamin Graham’s instruction for all of us not to overpay was considered irrelevant in the Internet world. Why a company like PDD was judged to be worth more than US$200 billion when its business model can’t make a decent profit was a mystery to some of us. We had written about it in the past.

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In my view, a conflation of factors has led to this super-bear market. First must be the disappointing corporate earnings. Besides poor fourth-quarter earnings, Alibaba and JD guided for challenging times ahead. In short, the online business has turned into a red ocean market from a blue ocean market.

What will make it very challenging in the coming years for the incumbents is the entry of Meituan, Douyin and Kuaishou. Unfortunately, it is happening when consumption is slowing down amid stringent regulations. As there are almost no entry barriers and no magic in online retailing, the new entrants can ramp up their operations very quickly for as long as they are willing to burn cash.

Investors seem to be getting tired and annoyed by these cliché opening mantras in quarterly earnings calls, “We are pleased to report another set of strong results …”, followed by analysts paying tribute before asking their question: “… congratulate management for another set of sterling results …”

What is so strong or sterling when the two most meaningful metrics, namely operating profits and net profits, show a loss or an 80% drop? Investors finally seem to realise that they may have been guided to a “path of rocks and scrubs” by innumerable ADR companies.

Investors may also have finally realised that China’s anti-trust regulations, protection of consumer rights, enhancement of worker welfare, safeguarding of national security, prevention of abuse of consumer data, and so on, are here to stay, and will eat into the profits of many ADR companies. Unlike in the US, corporate lobbying of politicians and regulators in Beijing will only land you in hotter soup.

It may be harsh to say that the majority of China ADR investors had bought them on price momentum, that is, they were buying them because others were buying them, which brings to mind John Maynard Keynes’ comparison of investing to a beauty contest, where judges are rewarded for selecting the faces most popular among fellow judges, rather than those they may personally find the most attractive.

I would go on to add that another miscalculation made by some investors is to justify the valuation of a stock by often comparing it to the most expensive superstar stock in the sector. Buying a stock that is 50% cheaper than a stock that is overvalued by 80% is not a bargain buy, is it?

US investors, who had shown indifference to crazy valuations for some years, must be asking hard questions now. One natural question to ask would be, “Why have the stock prices crashed 75%?” The bull-turned-bear might ask, “Why didn’t I ask the obvious question earlier?” The still highly convicted bulls might ask, “Is it time to buy more, or at least hold on for a recovery?” Some may ask whether it is time to again open Benjamin Graham’s Security Analysis book.

One new risk that China ADRs may be beginning to price in is the fall-out from the Russia-Ukraine war. It may have dawned on some investors that at some point, in an escalating Sino-US conflict, China assets in the US like ADRs can be frozen, as Russia and its tycoons have recently found out.

Just days ago, Roman Abramovich’s assets in the UK, including his Chelsea Football Club, were sanctioned and taken over by the UK government. Overnight, he cannot even step into the office of his soccer club without the permission of the UK government.

Against this backdrop, what will American and Chinese investors think of their investments in ADR shares? The Variable Interest Entity structure is an additional complication.

For the above-mentioned and other reasons, liquidity is rushing out of the ADR market. The crash is sharp and quick as many ADRs are not supported by fundamentals. In just a short few weeks, euphoria and confidence have given way to fear and panic, delusions to reality checks, no questions asked to many questions asked, sensitivity to valuation instead of indifference to valuation, and so on and so forth. Predicting the short-term direction of stock markets is a risky business.

Be that as it may, let me offer three scenarios:

A technical rebound takes place over the next week or next month, but it will likely be a dead-cat bounce because the concerns mentioned are unlikely to disappear or diminish. If ADRs are selling at a fraction of their intrinsic values, then a sustainable rebound can be expected. We have not looked at the entire ADR market, so we can only comment on those we know well. For instance, it is difficult to justify a persistently lossmaking company like PDD to be worth even US$40 billion, or JD, which has barely made a cumulative profit over 19 years, to be worth US$75 billion. Furthermore, if you build in the geo-political risk of Sino-US relations, the high-risk premium of your earnings model is likely to produce even more depressed prices.

Things return to the “Happy Old Days”. Having lost so much in the past year, some investors will have sobered up.

Most ADRs will be “stuck in the mud”. Most ADRs will sink deeper in the mud as they struggle with the headwinds. A few will do better as their fundamentals are stronger. Over the next 12 months, stocks will converge closer to their intrinsic values.

Value investing may take a sabbatical, such as in periods when markets are awash with liquidity. To write it off is foolish because there is no period in history in which stock prices — or for that matter, asset prices — defy “the gravity of fundamentals” for long.

To make hard decisions to not invest in the five- or 10- baggers which defy “the gravity of fundamentals” requires conviction and discipline. I am proud of my team’s discipline in staying away from ADRs, not because we do not understand them or have not researched enough of them.

Right now, we believe the China ADR game is over because “injured liquidity” is unlikely to turn reckless for a second time in the next 12 months. If we are right, then I would say again that a fairly large number of investors, retail and institutional, will bail out in coming months and add to the woes of China ADR bulls and their advisers.

Wong Kok Hoi is the founder and CIO of APS Asset Management. He has 41 years of investment experience, including CIO at Cititrust Japan, Senior PM at Citibank HK, and Senior Investment Officer of GIC. He was the recipient of the Monbusho Scholarship in Japan and graduated with a Bachelor of Commerce degree from the Hitotsubashi University (1981). Mr. Wong also completed the Investment Appraisal and Management Program at Harvard University (1990). Mr. Wong is a CFA charter holder.

China ADR game over with onset of 'super bear' market

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