BAT Stocks, Away! Investing in China's Big 3

There's a hot new acronym on the market. Unlike real bats, this BAT has good odds of making you a ton of money in the long run, with none of that pesky risk of contracting rabies. The BAT stocks represent three of China's biggest and most exciting companies -- Baidu (NASDAQ: BIDU), Alibaba (NYSE: BABA), and Tencent (NASDAQOTH: TCEHY).

In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Troy Springer walk investors through all three. Find out what each company does, how they're setting themselves up for the long term, how they differentiate themselves (or don't) from other Chinese competitors, what risks investors should watch, and more. And, of course, the hosts pick their favorite of the three, and explain how it stands out from the BAT pack. Tune in and find out more.

A full transcript follows the video.

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This video was recorded on Aug. 24, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It is Friday, August 24th, and we're talking BAT stocks. I'm your host Dylan Lewis, and I'm joined in the studio by one of The Motley Fool's investing interns, Troy Springer.

Troy Springer: How's it going, Dylan?

Lewis: Troy, great to have you in here!

Springer: Great to be here!

Lewis: You have spent the summer with our investing team. What have they had you work on?

Springer: It's a lot of free reign. I think that's like one of the big advantages of working at The Motley Fool. When you get hired here, they have a lot of trust in you, and you really can research whatever you want to research.

Lewis: Does your boss know you're doing this episode? Is that why you're buttering up here?

Springer: I honestly don't even think my boss knows I'm doing this episode. It's that free reign.

Lewis: [laughs] That's awesome! You made it through the gauntlet. It is not easy to get a job here as an investing intern or as an investing analyst. What recommendation would you have for next year's class of applicants?

Springer: I would say just engaging with The Fool. If you're a college student, podcast listener, maybe subscriber, get on the forums, play some CAPS. I know I put a lot of hours into CAPS, and that's almost where I feel like I got my job from.

Lewis: I know David Gardner is really big on CAPS. That's his baby. He really pays attention to CAPS. That's the thing to key in on there. Well, Troy, I'm having you on today because I wanted to get you on the show while you were here at HQ. We go back a little bit. Back when you were in college, we were chatting back and forth trying to figure something out for writing for the site. Awesome to have you at HQ now.

Springer: Definitely.

Lewis: You pitched this idea of talking about the BAT stocks, and how this is a space that is worth discussing now. I totally agree. We have talked about the individual components of the BAT stocks before, but we have never talked about them as a concept on the show. You want to break that down for folks?

Springer: Sure. BAT is kind of the Chinese equivalent to the FAANG stocks -- basically, your big technology powerhouses in China. What I think is especially attractive about the BAT stocks right now is that relative to the FAANG stocks, which have all had great years -- Amazon (NASDAQ: AMZN), up 62%; Netflix (NASDAQ: NFLX), 78% -- the BAT stocks this year have actually been flat or down. Tencent, minus 11%; Alibaba only up 2%. I think that that makes it pretty attractive right now. This could be a good time to start thinking about some Chinese stocks.

Lewis: And our third name in there, the B in BAT, is Baidu. What's been going on with these companies? How come they have not enjoyed the soar that we've seen with the rest of tech stocks?

Springer: I think the Chinese stock market has had a little bit of a rough year, given a lot of political turmoil with the tariffs and everything like that. Usually stocks are correlated. If the market's down, generally every stock will be down in the market, whether it deserves to be down or not. My argument is that a lot of these technology companies aren't really exposed to the tariffs. They rely on intellectual property, not necessarily the steel or soybeans that Donald Trump is leveraging on. So, to me, I feel like the sell-off is a little bit unwarranted.

Lewis: A lot of these companies operate almost solely in China.

Springer: Right.

Lewis: That's certainly the case for several of them. We're going to do a company by company breakdown here. Why don't we start out specifically with Baidu?

Springer: I'll do a little disclaimer here. A lot of times, we like to make the Chinese equivalent of an American stock. It's sometimes applicable, sometimes not completely applicable. With that said, Baidu is kind of considered the Google of China. They're the No. 1 platform in online search. They've currently had the weakest performance in the past three years, and actually are the cheapest of all the BAT stocks. What's interesting about a company like Baidu is that, similar to like Google, you have an app and you search for something, and then they can populate whatever you have with advertising, or maybe sell you other services through that platform. What's hurt Baidu recently is, in 2016, the Chinese government came out and said, "You can't advertise whatever you want." That's the problem with investing in Chinese stocks -- the government can dictate a lot of the terms. Since then, they've had a hit to their profitability.

Lewis: In fairness, this was in response to a lot of things that you might not want to have advertised being advertised on a lot of the Chinese platforms, right? You had these dubious or possibly even harmful healthcare services and treatments that I think actually led to some deaths in China. So, it makes sense that regulators came in. But this is an instance where, OK, maybe the growth projections for this business got modified a little bit because of what the Chinese government was saying.

Springer: Exactly. It's definitely taken a hit to their valuation. Another interesting thing about Baidu is, I know a lot of listeners are probably familiar with the Chinese video streaming service, iQiyi (NASDAQ: IQ), sometimes called the Netflix of China. iQiyi was actually a spin-off from Baidu. They recently IPO-ed that company to raise capital. But Baidu still owns 58% of iQiyi. As I talked about before, a lot of people like to compare iQiyi as the Netflix of China, but there's a little bit more competition. Netflix is the clear No. 1 in the U.S. I like to point out that Tencent's video -- a stock we'll talk about later -- actually has 438 million subscribers compared to iQiyi's 434 million subscribers. And, Alibaba, our next stock, is also in the mix in the video streaming space.

Lewis: I will say that I am guilty of making those comparisons. And actually, when we talked about iQiyi on the show, this must have been about a month and a half, two months ago, I did that exact thing. I described it as the Netflix of China. It's helpful to do that from a shorthand perspective, so someone can immediately understand the business; but, to your point, yes, there are a lot more competitors in that space that are the same size. There's really no one that is operating at Netflix's scale in the United States.

Springer: What's hard as American investors, it's hard for us to necessarily understand the intellectual property behind a lot of these things. You don't necessarily want to make the comparison like, "Oh, this company has the best content," because a lot of times, you and me aren't watching that content. It's in Chinese, and I don't speak Chinese. I think it's more important to think about the competitive advantages and network effects, as we'll get into later with some of the other companies.

Lewis: Something else to note with Baidu, in the scheme of BAT stocks, it is a small company, compared to the other ones we're going to discuss. I think a market cap around $80 billion. You look at some of the others, I mean, we're talking megacap.

Springer: $480 billion. Yeah.

Lewis: [laughs] Why don't we switch over to Alibaba? That is a roughly $450 billion-dollar company.

Springer: Alibaba is -- you know, I said I don't like these comparisons, but --

Lewis: But you can't help yourself!

Springer: You can't help it! It's easy to explain! A lot of people call Alibaba either the Amazon or the eBay of China. I think the eBay of China fits a little bit better, given their business model. Alibaba is a little bit more of a connector of sellers. They do B2C, meaning they buy products and sell them to consumers. They also do C2C, which is like the eBay model, where the consumer is selling to other consumers, and they connect those consumers. This is a business where they don't actually own a lot of the warehouses, but they have the infrastructure in place to connect all the e-commerce players.

Alibaba is probably the most well-known. It's currently also the biggest, 40% of the Chinese population uses Alibaba. Jack Ma, their founder, he's considered a visionary, one of the bigger leaders in China. But they also have expanded their network to include processing payments. 40% of all online payments in China are processed through Alipay, which is a very lucrative business, considering what PayPal and Square have done in the United States. They also have probably the biggest cloud computing business currently in China.

Lewis: And that is something that makes them very similar to Amazon, right? That makes that comparison a little bit stronger. If you spend any time looking at Amazon, you're like, OK, the e-commerce reach is there, the Prime subscriber base is great. But, what powers that company is AWS. That's what gives them the profits to invest in all of these other things. And Alibaba has that.

Springer: Right. Another competitor to Alibaba that a lot of listeners are probably familiar with is JD.com. JD.com is a little bit more similar to Amazon in the fact that JD.com is the asset-heavy business model compared to Alibaba's asset-light business model. What that means is that JD has actually invested a lot in the infrastructure of delivering. That means they can usually have faster delivery, but it also puts a big dent on their margin. JD only has like 4% operating margins. I think Alibaba is in the 35-40% range. It's a huge difference. But they're both growing very, very fast.

But if you were to compare this to the U.S. market, in the end, it was the asset-heavy business model of Amazon that won out. Whether that plays out in China, we'll see.

Lewis: C2C gives them these gaudy margins, for the time being, but it might be the better long-term play to be a little asset heavy.

Springer: Possibly. JD.com, also owned 17% by our next stock, Tencent.

Lewis: We're going to talk about that on the back half of the show. That will be our last BAT stock to cover, and we will do a little discussion, big picture, after that. Alright, Troy, we're going to hit the T now in BAT.

Springer: Let's do it!

Lewis: That is Tencent.

Springer: Tencent, full disclosure, is probably my favorite of the three. It's the only stock I own out of the three.

Lewis: Tencent is also the only stock of the three that I own. We're playing a home game here.

Springer: Tencent, there's less U.S. comparison here because they're a little bit more diversified. They own basically what's considered the Facebook of China through two different platforms. One is WeChat, and one is QQ, with WeChat being a little bit of the stronger platform.

What's interesting about these companies is, they have about one billion users for WeChat of a population of 1.4 billion. Almost every single person in China who's technology-enabled is using WeChat. That's just crazy to think about. Facebook doesn't even have that reach in the United States.

Tencent is a huge and diversified business. Actually, their biggest driver of their businesses is their gaming, which has recently caused them to dive down a little bit in the past couple of weeks, as Chinese regulators have stepped in and said, "No, you actually can't make money from these games because that may not align with the interest of the government's policies." But this is something that's happened to China before. I think the general trend is toward liberalizing the economy and liberalizing the different forms of media that the Chinese government allows the Chinese people to consume.

I think the biggest advantage of Tencent is their distribution platform, how the Chinese economy works is that it works similar to how our iPhones work. You have apps, but instead of these apps being distributed through iTunes, they're really distributed through WeChat. So basically, how I compare what Tencent has is, they have an Apple -like distribution system through their WeChat app that basically everyone in China is connected to. So, if their streaming service, their music service, video games -- a lot of people play video games in China on their phone. Actually, the majority of people do. And it's all distributed through that one app.

Lewis: You know, I saw a Statista email today that was doing a breakdown of Chinese consumers. They said 98% of Chinese consumers are accessing the internet on mobile. That speaks to how people are accessing content and what they are doing with that access. You mentioned mobile gaming, but they also have payments, ride hailing, pretty much anything you could roll into or want to be able to do. It is incredible, the bundle of companies on the American side that seem to fit into what WeChat does. It's like a PayPal-Uber-Activision Blizzard hybrid. It's unlike anything we have here in United States.

Springer: It really is. I think the United States would be a little bit uncomfortable with how powerful this company is. But in China, in a country that's very centralized, kind of communist, I think they're a little bit more comfortable with having these big companies. In the past, they've had these big state-run industrial companies that have just been huge monopolies. I think they're a little bit more comfortable with this in Tencent's case.

Another thing I'd speak about Tencent is, Tencent also owns a lot of popular American properties. They own 40% of the company that makes Fortnite.

Lewis: Epic Games.

Springer: They own 40% of the company that makes PUBG, which is actually one of the games they weren't allowed to make money from. And they actually own a stake in the company that makes League of Legends. These are three of the biggest games in the world right now, all owned by this Chinese company.

Lewis: And they also have stakes in Tesla and Snap. Depending on how you feel about those companies, maybe that's not a selling point. I know that I've spent a lot of time on this show bashing Snap, so take that with a grain of salt. But, they are clearly investing in a lot of different spaces. I look at what they do, and it is very reminiscent of how Alphabet is handling capital allocation. They're saying, "OK, we have this property, Google, that is making a ton of money for us. We can spread some bets elsewhere. And if one of those really takes off, then we have a huge business segment to grow into that will help us really meaningfully move our overall market cap."

Springer: Exactly. They did something that I think was really smart with Spotify earlier this year. They basically made an equity partnership with Spotify, saying, "We'll buy some your company and we'll give you some of our company, and we'll just share technology." Spotify, as an European company, doesn't necessarily have the know-how to penetrate the Chinese market. But Tencent just says, "Cool, we'll just share. You can have some of our money and we can have some of yours, and then we'll distribute our platforms out."

Lewis: Yeah, that's a smart way to expand. They have the benefit of doing that, being in China, where without a joint venture, you really can't do anything with an outside firm. But for them to be able to essentially take trade secrets or take whatever institutional knowledge Spotify might have, and be willing to share with them, and then apply it to their own music streaming product or their own distribution network, is a really bright move on their part.

OK, so, we've talked about three companies. We both own Tencent, so I think we might be a little bit biased here. But I have to ask the question anyways -- of the three, which one are you most excited about right now?

Springer: Definitely Tencent. I consider Tencent -- recently, after this drop -- to be probably one of the best buying opportunities I've seen covering stocks. [laughs]

Lewis: I hope you're right, as someone that owns shares!

Springer: I hope I'm right, too. But, really, I think you can't go wrong buying a basket of all these companies. I think what you're getting right now is, you're getting a little cheaper multiples than you are in the United States at faster growth rates. If you want to diversify away from the U.S. markets and follow a market that has a lot of the network effects and big power of the FAANG stocks, as you've seen in the U.S., I think even owning all three of these companies is probably a decent idea.

Lewis: Yeah, I think that's a good way to bet on China's future. The interesting thing with these businesses, and something that I think is worth keeping in mind when you're thinking about what your gains might look like, is, buying some of these companies is a lot like buying an Alphabet. They are at a certain scale where it's a lot harder for them to double anytime soon. That said, it is a lot different than buying an iQiyi, where you might get --

Springer: Up 100, down 100.

Lewis: Yeah, some amazing returns, but you also might wind up just throwing away your lunch, basically, with that stock. So, maybe curb your enthusiasm a little bit with the returns you'll be getting with some of these companies, specifically Tencent and Alibaba, just because they are already so large. But I think you could do a lot worse than buying all three of these and setting and forgetting it.

Troy, thank you so much for hopping on the show!

Springer: Of course, it was a lot of fun! Thanks, Dylan!

Lewis: How much longer are you here?

Springer: I'm here for another two weeks.

Lewis: Alright, maybe we'll be able to squeeze you on one more time. [laughs]

Springer: Maybe!

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, you can shoot us an email at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass. For Troy Springer, I'm Dylan Lewis. Thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of GOOGL, Amazon, AAPL, FB, iQiyi, PYPL, Tencent Holdings, and TSLA. Troy Springer owns shares of GOOG, Amazon, FB, JD, and SPOT. The Motley Fool owns shares of and recommends ATVI, GOOGL, GOOG, Amazon, AAPL, Baidu, FB, JD, Netflix, PYPL, SQ, Tencent Holdings, and TSLA. The Motley Fool has the following options: long January 2020 $150 calls on AAPL, short January 2020 $155 calls on AAPL, and short September 2018 $80 calls on SQ. The Motley Fool recommends EBAY and iQiyi. The Motley Fool has a disclosure policy.