We’ve highlighted the outperformance of Chinese stocks several times this week, so we decided to go deeper into one sector: data centers.

The “brains of the internet”

Data centers process and store data generated from all the tech we use. As the world moves digital, the demand for data centers increases.

• In the U.S., commercial real estate firm CBRE sees data centers as a sector with “extremely positive fundamentals.”
• But stock prices haven’t reflected that sentiment as inflation took over the economy.

China is a completely different story with low inflation, falling interest rates and a government providing stimulus to boost its economy. Just like in the west, data centers are a crucial part of the digital economy. In the past two years, China took data center stocks on a roller coaster:

Way up: In 2020, China announced a “new infrastructure” to ramp up its digital infrastructure — sending several Chinese data center stocks up triple digits.

Way down: In February 2021, Chinese stocks peaked as China cracked down on its tech sector — sending data centers stocks tumbling with the rest of the market.

Ways to play the Chinese data center sector

A group of U.S.-listed Chinese data center stocks — including Chindata Group Holdings (NASDAQ:CD), VNET (NASDAQ:VNET) and GDS Holdings (NASDAQ:GDS) — have fallen an average of 74% since Chinese markets peaked in mid-February 2021.

In an April interview with Pinnacle Associates Portfolio Manager Randolph Baron shared GDS as one of his top three positions. Baron goes deep intoGDS

’ bull case in the lengthy interview.

• GDS operates data centers across China — with Alibaba as an anchor customer — and has expanded into the Southeast Asian region.
• GDS has industry-leading earnings margins with valuations significantly cheaper than U.S. data center companies.

“If you think China’s internet is going to grow over time, this is the play,” explains Baron. He looks three to five years out and expects many of the issues surrounding China (i.e., Chinese delistings, COVID lockdowns) will get resolved.

Investors: Play the game you know

When investing in China, regulatory and government risk is a significant factor to consider. At any moment, China can destroy an entire industry with one announcement — as it did to the private education sector last year.

Staying on the right side of China’s policies is crucial, but index fund investing for exposure to a basket of stocks may be a better option for most investors. See here for two popular ones:

• iShares MSCI China ETF (NASDAQ:MCHI) — which gives exposure to a broad range of Chinese stocks in various sectors.
• KraneShares CSI China Internet ETF (NYSE:KWEB) — which gives exposure to Chinese tech companies.