When Ant Financial’s IPO was cancelled in November, investors dismissed it as a personal punishment meted out to Jack Ma for criticising the regulators and the system. Alibaba stock declined less than 10% over two weeks.
When the antitrust department summoned the Internet and e-commerce companies for afternoon tea almost every week from November and warned them about anti-competitive practices and other misdeeds, investors largely ignored that. When Didi Global ignored the cyber security regulator’s urging to delay its IPO, investors enthusiastically took up all the shares on offer.
Within two days of the IPO, six regulatory agencies were sent in to conduct their investigations on issues including customer data protection, cyber security compliance. Its stock price declined 12% from its IPO price over two weeks.
Then came the nuclear strike. After-school-tuition (AST) for K12 curriculum will be controlled and will be out of bounds to all private capital. President Xi Jinping had actually warned two years ago that K12 tuition should not be a profit-driven enterprise, but AST companies and their shareholders ignored the warning.
Instead, billions of fresh capital poured into listed and unlisted companies. AST leader New Oriental Education saw its stock price collapse 68% over two weeks and was 90% lower from its peak in February. TAL Education Group and Gaotu Techedu dropped even more. Because investors suffered massive losses of US$100 billion ($135 billion) in just three AST stocks over five months, they are beginning to ask questions about everything related to China. Panic, like exuberance, blurs the mind. Rumours swirled, with speculation about which industry will be targeted next to the privatisation of Didi to the delisting of American Depositary Receipts (ADRs) and so on.
Almost overnight, China’s regulators are accused of hammering out arbitrary regulations to stifling enterprise to targeting billionaires to harbouring xenophobic attitudes and so on. What has happened in a few short months? Why are regulators suddenly on overdrive? Is China now “un-investible”? This short note attempts to answer some of the questions.
No common driver
Firstly, the regulatory actions against Ant Financial, Didi, e-commerce and internet companies, AST companies and others are all driven by completely different considerations. Because the actions took place in a compressed time frame, it would appear to some that there is a common thread, driven by a common force.
Let’s review Ant Financial’s cancelled IPO. It was cancelled for two major reasons: one is the systemic risk it posed to the financial system and two, the usurious interest rates charged on peasants and youths.
Didi’s concerns were data protection and cyber security (national security). Internet and e-commerce companies were issues of antitrust behaviour, worker welfare, wastage of capital, including others.
AST was complex with multiple dimensions — political, social and economic. The Communist Party of China (CPC) had been unhappy and concerned that AST companies had gone out of hand. AST players went all out to solicit business, even from pre-school pupils, in advertising blitzes with misleading ads after they had raised billions of dollars last year from the public market and private equity funds. Parents had complained for years about the high cost of AST and the stress their children are subject to from a young age.
As a result, young Chinese families show scant interest in making the most of China’s two-child policy, after decades of sticking to the one-child policy. Some sociologists believe that the high cost of education is a major reason for the declining birth rate in the country. The Party also fears that high AST costs would create a class system where children in rural areas would always be outdone by their wealthy urban counterparts.
An overarching objective of the Party is to create a fair society where every citizen will have an opportunity to share and relish the China Dream. This has always been the manifesto of the CPC. It was formed by 50 members in 1921 with this ideal. Although it has 95 million members today, this ideal is not lost, on the senior Party cadres at the very least.
Regulators on overdrive?
To read the minds of the senior Party cadres and government officials, it may be instructive to look back at the country’s economic development history. In the early decades of economic development, regulators’ mandate was to facilitate foreign investments, provide a friendly and supportive regulatory environment, cut out red tape, encourage enterprise and job creation.
In short, the regulators’ mandate was not to regulate and stifle entrepreneurship but to work hand in glove with businessmen to ensure their success. This partnership brought enormous success to the private sector especially and it is a major factor behind China’s economic miracle.
In the early years when China faced chronic unemployment, Deng Xiaopeng cajoled the nation to go out to expand businesses and famously said in 1984 that “It doesn’t matter whether a cat is black or white, as long as it catches mice.” Deng’s brilliance and pragmatism set the foundation which successfully lifted 800 million citizens out of poverty.
But China’s economic miracle was achieved not without costs. The environment was compromised, workers worked long hours in dire working conditions for meagre wages with poor or even absent social insurance, the wealth gap widened, behemoth companies abused their market position, and distortions were seen in some segments of the economy as capital markets accelerated some of these distortions and excesses. It is no wonder that companies took advantage of this climate of laissez-faire capitalism to maximise profits. Is it a surprise that a late developer like China has minted the largest number of billionaires ever?
Here are some examples. Fraud and bad management in the licensed but lightly regulated peer-to-peer (P2P) industry led to the collapse of thousands of P2P lenders in China between 2016 and 2020, where millions of small individual lenders in China lost a total of US$115 billion out of US$218 billion of outstanding loans.
FinTech firms, also lightly regulated until this year, were charging usurious annualised interest rates of 18–40% on blue-collar workers, peasants and youths. E-commerce companies raised billions every year to fund price wars that included selling below costs, to slowly and steadily decimate the six million mom-and-pop shops across the nation. Workers in the logistics and food delivery industry work excessively long hours under dire conditions for low wages, with limited or even non-existent medical insurance and pension benefits. Business excesses and capital market distortions are probably most evident in the online business. Some even sell products for one yuan!
In the short term, the cash burn was rational on the part of founders and shareholders of the e-commerce companies because investors would pump up the stock price for as long as they can produce topline growth, even if they cannot make a profit in the future.
Just before this year’s July sell-off, investors crazily valued six-year-old Pinduoduo at US$250 billion in February. It is a heck of a lot of money for a new company that has yet to make a dime, with fixed assets of just US$80 million and with only two to three years of cash left to burn.
Pinduoduo is not the only stock with a crazy valuation. The government has been watching these developments with grave concern as it could see the flaws and distortions in the economy and the capital markets. This worry is probably best illustrated in this commentary by a senior government official in The People’s Daily mocking e-commerce companies for being obsessed with selling cabbages rather than investing in real innovation.
The new regulation on the AST companies is most likely a small piece of a broader set of education reforms that we will hear more about soon. As the document was issued by the State Council, the order must have come from the very top in the Party. The Education Ministry merely carried out the order.
In our assessment, a good starting point to predict the next piece of regulation is to identify the economic dislocations, market abuses, and capital market excesses seen predominantly in the private sector that have been created by decades of laissez-faire capitalism. It is fair to say that regulations are behind the curve when compared to most developed countries.
Take these two examples. The US and the European Commission took antitrust actions against the tech giants a decade ago and had imposed fines to the tune of tens of billion dollars while China took action only less than a year ago and thus far only Alibaba has been fined meaningfully.
The second example is consumer finance loan interest rates. Most countries have caps but China had only provided rough guidelines from just seven months ago. Frankly, I can’t think of another country that has practised laissez-faire capitalism as religiously as China in the last three decades.
It is worth pointing out that the Chinese economy is still a two-tier economy where the state-owned enterprises (SOEs) sector is essentially commanded by the central, provincial and city governments while the private sector is allowed to develop and grow with light regulatory touches. No wonder even American companies under former President Trump and now President Biden have not been tempted by incentives to move their operations back home.
Be that as it may, there is absolutely no evidence that regulations are intended to slow growth, much less stifle entrepreneurship and innovation. Rather it is intended to ensure that companies apply healthy business practices while complying with laws and regulations, instead of engaging in short-term capital market games and the like.
Finally, the reality is that China’s regulations have been behind the curve for historical reasons.
China ADRs: Whither, wither?
Investor sentiment towards the China ADRs and China stocks took a hard knock in the past week. Despite assurances from Fang Xinghai, vice-chairman of the China Securities Regulatory Commission, that the government has no plans to force companies to return to Hong Kong and China for their listings, investors worry that hostile Sino-US relations might eventually lead to this outcome.
Fear is increasing that companies strategic to national security, like Alibaba and Baidu, might be compelled to give up their US listings. This is so that they are not hostage to foreign capital, and not subject to the rules of overseas regulators, such as the need for ADR companies to submit auditor notes to the US Securities and Exchange Commission.
The view may be that if global investors want to benefit from the growth of the Chinese unicorns, they can invest in Hong Kong listings or make use of the Northbound Stock Connect, ultimately benefiting the development of China’s financial centres. Artificial Intelligence, for example, would be a strategic industry, regardless of whether the company is a top-tier or third-tier player. For instance, a value retailer of lifestyle products like Miniso Group would be non-strategic and would not attract the same level of scrutiny and policing. Rather than a blanket rule, regulatory targets are likely to be specific, like how companies with data for over a million users must undergo a cyber security review before listing their shares overseas.
Be that as it may, investors are jittery and are expecting the worst, including for Chinese companies with Variable Interest Entities (VIE) structures. All said and done, against the backdrop of escalating tensions between China and the US, many ADRs will inevitably continue to face these twin regulatory risks. Until this tension is dialled down, investors are probably better off being invested in China A and H shares.
Crowded trades
One discovery from the mini-crash is that several large blue-chip China managers suffered heavy losses because of their concentrated bets in the tech and education sectors. Even individual investors held the same popular names. One uncertainty in the coming weeks and months is whether these investors would rebalance their portfolios to reduce their concentration risks and risks from crowded trades. Another casualty was investment managers adopting the dollar-cost averaging approach. They were hit hard, especially those who favoured AST and tech stocks. This strategy, which had worked phenomenally well in recent years, backfired big time in recent months.
Risks and opportunities
For the next 12 to 24 months, we would avoid:
1. ADRs, even if they have already fallen by a lot. There is still room for valuations to fall for overvalued internet stocks and healthcare stocks as well as crowded trades common to many China A and All-China strategies. That said, we do not think China will smother the medical sector and policy will continue to support innovative players, cognisant of Japan’s experience that had led to an over reliance on foreign suppliers after massive cuts in R&D.
2. Labour-intensive companies like Meituan and JD.com that do not provide adequate medical, insurance and/or pension benefits. In our view, the central government will likely make them bear a chunk of such costs.
3. Companies that are engaged in dubious business practices and worker exploitation that regulators may target. One red flag is companies with overly high ROEs like consumer finance companies that lend at usurious interest rates, or companies that underpay their workers and provide almost no social insurance and pensions. Put in another way, the “S” component of ESG will become an increasingly important driver of investment returns.
4. Stocks bought on concepts and expectations that are sizzling and hazy. They would be most vulnerable if earnings disappoint and are unable to justify their lofty valuations. Where are the opportunities?
We would focus on:
1. Non-Internet technology companies and the localisation of high-end manufacturers like those in the semiconductor ecosystem, precision machine tools and parts for the renewable energy industry. They all enjoy the tailwind of government support as China moves towards a future of self-sufficiency in leading-edge semiconductors, net-zero carbon emissions, and energy security.
2. Stocks with ROEs of 10–12%, P/Bs of 1 time and P/Es of 10 times are likely to be back in favour. With our tongue firmly in cheek, an ROE of 50% is alright if they are selling to the bourgeois, not so if they are selling to the proletariat. We would like them more if they can satisfy the other criteria in our APS Four Alpha-Hats investment process.
3. Companies with resilient earnings and lower risk of earnings disappointments. Ironically, the SOEs that are relatively wellrun may outperform in this environment.
4. Growth stocks or Structural Alpha stocks, especially those in industries identified in the Made in China 2025 blueprint, may shine.
Sustainable, quality growth to a modern China
In times of euphoria or distress, illusions can creep into one’s mind. The recent crackdown on tech and the market gyrations have not altered an iota of China’s long-term growth strategy and its policies — at least I have not detected any evidence of it. Why would they?
In our assessment, the recent crackdown is tantamount to what the Party had stated on numerous occasions for some time, that policies must now aim for sustainable, quality growth. Figuratively speaking, President Xi and his administration want healthy cats, not just any cat, to catch the mice, and to systematically catch them without causing disorderliness and damage to the ecosystem.
Chinese policies from Deng’s time have elements of both socialism and capitalism. Because capitalism was a taboo word at that time, Deng had to use the term “Socialism with Chinese characteristics”. Like in most countries, China is also looking for the right balance in the mix of socialism and capitalism to successfully power the nation ahead.
The sharing of economic prosperity and the creation of safer work environments, as well as the reduction of stress in workplaces, in schools, and within families, will all lead to a more stable political and social environment.
Like all things in life, you adapt your strategy and tactics to the changing circumstances. In a word, President Xi wants the China Dream for all 1.4 billion citizens.
Wong Kok Hoi is founder and chief investment officer of APS Asset Management
