Portfolio Insights: China To Embrace The Cloud

For most investors, 2017 will likely go down as the year of technology. It was the strongest-performing sector in nearly every country and region, and if an index or manager was under-weight the tech, it’s extremely unlikely that they were able to outperform their benchmark. At WisdomTree, our best-performing strategy on an absolute (and relative) basis against its market capitalization-weighted benchmark has been our China ex-State-Owned Enterprises Fund (CXSE). Year-to-date, the Fund has returned an impressive 67% compared to a 47.7% return for the MSCI China Index.1

The key driver of those returns? Given that our Index methodology eliminates businesses with greater than 20% government ownership, the resulting portfolio is over-weight tech through our 9.2% and 8.8% weight in Alibaba and Tencent, respectively.2 For most tech investors, one of the most exciting attributes of these businesses is the fact that they’re creating new tools that seek to change the way we live. One such industry that has caught investors’ attention is cloud computing. Below, we contrast the current state of the cloud in the U.S. and China and then try to discern what it may mean for CXSE. In our view, Alibaba’s and Tencent’s cloud-based technology could reach levels of dominance in Asia not dissimilar to Amazon’s and Microsoft’s dominance through much of the developed world.

Macro Trends

In order to remain bullish on China and the ex-SOE theme, it’s imperative that investors be aware of what’s driving current earnings but also how they’ll grow into their elevated multiples (approx. ~30x forward P/E3). As we’ve seen in most tech high fliers, their ability to meaningfully pivot outside of their core businesses has separated businesses such as Facebook from those such as Snap. Central to our views on China tech are the trends we’re seeing in cloud computing.

In a chart first presented by Citi, we compare the relative size of the public cloud market in the U.S. vs. China. Unsurprisingly, the market in the U.S. dwarfs that of the Chinese by nearly 30x.4 However, given its smaller base, we see dramatically higher growth rates in the Chinese market. AAdditionally, we believe the cloud could be ground zero for China’s stated goal of transitioning from a manufacturing and trade-based economy to one comprising primarily consumption and services. In fact, we’ve heard several times over the last couple of years that the Chinese government is actively pushing SOEs as well as smaller firms to embrace technology by migrating segments of their business into the cloud. In only three years’ time, the International Data Corporation (IDC) predicts that the U.S. advantage will have narrowed to only 23x. As growth in the U.S. begins to plateau at around 16% per year, China’s growth will continue to accelerate. While China currently represents a smaller segment of the global market, we believe Chinese firms may possess a structural advantage when growing the cloud in Mainland China as well as across Southeast Asia.