Barron's April 5, 2019

Silicon Valley’s super-start-ups are teasing investors about whether they will follow Lyft to the public market. Chinese unicorns are less coy. At least eight raised more than $1 billion through initial public offerings in Hong Kong or the U.S. last year, offering a smorgasbord of access to the country’s burgeoning economy.

There’s just one problem: Nearly all of the issues have been dogs. Shares in phone maker Xiaomi (ticker: XIACF) have plunged 45% since a few days after the company’s $4.7 billion IPO. Food-delivery service Meituan Dianping (MPNGF) is off nearly 30% since raising $4.2 billion.

Timing was part of the problem. The companies looked to cash in on the roaring Chinese market of 2017; they ran into 2018’s wall of worry instead. But even with sentiment on China improving this year, investors remain markedly cautious. “I think the market’s being quite rational,” says Andrew Mattock, lead manager of the Matthews China fund. “We don’t know when or if these companies will become profitable.”

The U.S. tech landscape is awash in private funding, allowing young companies to incubate longer before going public. China is different, Mattock says. A wave of venture capitalists poured in when the economy was at its peak half a decade ago. Now they want out, sometimes prematurely. “None of these companies are generating operating profits, and some, not even gross profits,” says Edmund Harriss, who manages Asian funds for Guinness Atkinson. (Lyft is also in the red operationally, but earned $913 million gross last year.)

Competition is fiercer and more fluid in China’s emerging economy than in more established ones, so market niches can evaporate quickly. Xiaomi has been heavily damaged by a surge from (privately owned) competitor Huawei, notes Harriss. At the same time, competition is skewed by China’s two giant first movers– Alibaba Group (BABA) and Tencent Holdings (700.Hong Kong)—whose tentacles reach across the digital universe. “Alibaba or Tencent have a huge potential for suffocating almost any business,” says Young Kim, a portfolio manager at the Columbia Emerging Markets fund.

That’s just what may be happening to Meituan Dianping, whose post-IPO prospects have dimmed as Alibaba scales up its deliverable eats business. The only 2018 Chinese tech IPO that has delivered is Tencent Music Entertainment Group (TME), which has jumped by a third since raising $1.1 billion on Nasdaq in December.

More attractive Chinese issues might arrive later this year. Ride-hailing front-runner Didi Chuxing, valued at $65 billion in its last private financing round, and social-media phenomenon Bytedance ($75 billion), are both presumed to be in the pipeline. The elephant just outside the room is Alibaba spinoff Ant Financial, which private-equity backers have priced at $150 billion. It was poised for an initial offering last summer, but waited, probably wisely. “Some of the companies in line this year are a lot more established,” Kim says.

In addition, authorities promise to add a technology and innovation board to the Shanghai Stock Exchange this year, with some 50 smaller-cap IPOs waiting in the wings, according to UBS . Only courageous investors need apply.

China’s new economy may be closer than the West’s to the disruptive, hypercompetitive model that U.S. techies claim to admire, despite its two dominant players. The turbulence is challenging for investors, however. “We’re quite excited about the environment in China,” Andrew Mattock says. “The biggest risk is [not] picking the right stocks.”