Key Investment Issues Related to the Recent Regulatory Events in China

The following is an excerpt from our monthly report / newsletter to clients.

Here is a recap of our investment views, without getting into a long-winded argument about who is right or who is wrong, what China should do or should not do… After all, we are here to make money, not win arguments.

(1) Policy risk is everywhere…and it will remain a fact of life for investing in China. Investors sometimes forget that, and naively believe that certain sectors (e.g. private consumption) are immune to policy changes. Evaluating the policy risk has always been an integral part of our investment process, by the way.

(2) The future of Chinese ADRs is uncertain. Not that the U.S. or China will permanently ban the listing of Chinese companies in the U.S. Yet it will be more difficult for the ADRs to live with two sets of different or even opposing standards. Not to mention that both sides are demanding higher transparency and more accountability from these companies. The compliance challenge will only increase from here.

(3) Is there a corporate governance angle here? Absolutely. Let’s not just focus on the policy impact, but also look at how well these companies handle this crisis. Good companies like Tencent and Alibaba should eventually survive and likely become stronger. Others may not. The education firms will have to change their business models, but not every company can successfully do so... Governance research is the most important aspect of our process. We previously shunned the education firms for poor governance.

(4) This is NOT a “crackdown” on all things tech related. I’ll break this down into three areas: (a) Core technologies (mostly hardware) like semiconductors, AI, 5G, smart manufacturing and cloud computing will continue to see strong government support. (b) Internet platforms like Tencent, Alibaba, Meituan and Didi will see more stringent regulations, but it’s not the government’s intention to weaken or destroy them. Same things can be said about real estate and private health care, which face a different policy risk today. The government also has no interest in eliminating these companies. But they all need to learn how to co-exist with the public system harmoniously, and operate under a new policy framework, be it financial stability, anti-monopoly, cybersecurity, personal privacy, green energy or improving the quality of life. (c) For sectors and companies that clearly go against the policy, the government has no choice but to execute a complete overhaul. It will destroy certain business models and companies along the way, but this is considered a necessary cost of the reform.

(5)?The recent events are definitely hurting the global investor sentiment on China. We are concerned with global investors possibly reducing their overall China exposure as a result. Most of the selling so far is done by hedge funds and fast money. Easy come easy go. And we are yet to see a major unwinding by the long-term, strategic allocation to China. This is potentially a bigger risk.

(6) Within Chinese equities however, we expect a continuing shift to China A-shares (from the ADRs). There are several drivers for this change. First, some investors may view the regulatory issues of A-shares as simpler and less challenging. Second, people increasingly realize they are massively underweight in A-shares (just 11% of all China and less than 0.5% of global equities by index weight). Third, China A-shares offer many stocks that are consistent with the government policy shift (e.g. semis) and/or face lower policy risk.

We expect more attention and money flow to China A-shares.