Quality Growth Boutique
Global equities specialists since 1984. We provide a boutique investment experience for institutional and intermediary clients around the world.
Recently the Chinese Communist Party (CCP) has become more assertive, causing concern among the international investor community. What initially appeared as a singular event, i.e., regulators forcing Ant Group to cancel its IPO, has now grown into a much bigger trend expanding beyond the large internet companies. The latest move by the CCP, targeting the USD 100 billion education industry, is considered even more worrying as it appears likely that the value of many education stocks may be going to zero. This move has led to an increasing concern that further policies will cause significant investor losses in other areas, as regulatory moves may potentially lead to profitability being significantly eroded or ownership structures becoming invalidated. The key in helping investors navigate and, hopefully profit from these changes, is to understand the bigger picture and what the government is ultimately trying to achieve.
China’s government is increasingly shifting priorities away from overall economic growth towards inclusive growth. Policy changes so far have just started to focus on improving the cost pressures that middle- and lower-income families face. This is why the education sector is now being targeted; it is one area where families are overspending in an attempt to compete to get their children the best scores on entrance exams and hopefully one of the very limited spots at the best universities. Arguably, this industry is not going to go away. So long as parents have an incentive to give their kids or grandkids an advantage, they will spend the money. Instead of spending on larger listed platforms, many will simply shift their spending towards informal arrangements with individual instructors.
Also in the spotlight is housing and health care costs. Health care costs, such as pharmaceuticals, have already faced significant pricing pressure. As such, there is less room for them to surprise on the downside. Up to this point, non-essential medical services have been believed to be safe from pricing pressure. Businesses such as Aier Eye Hospital, which largely operates outside the government-funded system and yet is an essential service, may be okay; however, considering the growing risks of unknown policy changes, it may not be worth paying 100x earnings as this leaves room for significant losses. Although the probability is low, there is a chance that one day the government may decide such businesses should also operate as not-for-profit.
Affordable housing is certainly a large concern but may be difficult to address by immediate policy changes. The government has been consistently attempting to keep real estate prices in check for a long time, albeit with limited success. The fact that construction is a significant source of municipal finances, as well as a significant employer, should limit the risk of drastic changes. With builders facing increased funding pressures, the government may be hesitant to do anything too extreme in this area for the time being.
So far, policy changes have been directed towards immediate impact, but over time another area that could help would be to focus more on conspicuous consumption by the rich. This would mean businesses like baijiu, premium automobiles or European luxury goods should be considered incrementally riskier investments. Unless the government wants to finally kill Macau, gaming should be less likely targeted given the lingering effects of previous corruption crackdowns and Covid-related restrictions on travel.
Tech companies are still recognized as leading the innovation charge, but demands will be higher now. Investors should expect increased R&D spending, which may not necessarily translate into new revenues or profits, and the net result will likely be that returns on investment will deteriorate over time. Conversely, companies that do not show meaningful commitment to visibly improving their social contributions are at higher risk of being targeted for further scrutiny.
Recently at a small- and medium-sized enterprise (SME) forum in Changsha, Vice-Premier Liu He reaffirmed his commitment to supporting SMEs as the engine for job creation. In the event regulators see platform businesses are overly aggressive on channel costs, this could be seen as a risk. The government has already started to focus on wages, benefits and the work pressures of gig workers. Further potential measures should not be written off.
Investors in China should recognize that CCP policies take precedence over all else. There is no way for companies to appeal legally or even in the court of public opinion. While there has not been any indication that the commitment to capital markets and private ownership is slipping, investing in China should always be seen as higher risk. This risk has always been there, but it has now become more obvious. While government officials have recently attempted to soothe the markets and reaffirm their commitments to opening markets to foreign investment, this commitment stands only so far as it is seen as beneficial to government objectives.
Because of the recent changes, international investors are reassessing the risks of the longstanding VIE structures, which allow high tech businesses to circumvent foreign investment restrictions. But recent comments from government officials continue to indicate there is little risk of change currently. Although, with the issues raised by the Didi IPO, changes will be made to discourage—but not entirely restrict—US IPOs. On the US side, for now the SEC is going to require increased risk disclosures but still allow Chinese companies to list. Longer term, because of a disagreement over disclosures and access to documentation between the US and China US ADRs, at least for companies operating in designated strategic industries, a US listing may no longer be tenable. Now that Hong Kong has become a very effective alternative, the Hong Kong exchange should ultimately be the net beneficiary. The Shanghai STAR market may gradually see some opportunities as well.
Increasingly there are indications the government is recognizing that changes have come too soon and too fast. Historically, the government has been active in managing market expectations, and it recognizes that significant and disorderly market selloffs can have broader negative ramifications for the economy at large. Hence, the government likely will look to do more in the immediate future to stabilize the selloff.
If the government is successful in this broader policy goal of reducing the financial pressures households and small businesses face, the first thing to benefit would most likely be rising discretionary spending. Thus, businesses in sectors such as consumer staples, smaller discretionary spending or travel and entertainment should start to see more immediate gains. In the face of these changes, current and ongoing, the best approach is to assess what the government is trying to achieve and try to make investments in-line with the direction--or at least avoid investing in those businesses that stand in the way of those objectives.
The views and opinions herein are those of the individuals mentioned above and do not reflect the opinions of Vontobel Asset Management or Vontobel Group as a whole. The views may change at any time and without notice. This document is for information purposes only and does not constitute an offer, solicitation or recommendation to buy or sell any investment instruments, to effect any transactions or to conclude any legal act of any kind whatsoever.