Shep Perkins, CFA
Chief Investment Officer, Equities
Investors in China’s technology stocks have certainly had a memorable year. As we witness a monumental shift in this investing universe, “why bother” has become a dominant narrative for many investors. We, on the other hand, believe the sector now offers compelling buying opportunities. But finding them requires an understanding of the changes that have occurred and an analysis of the Chinese government’s long-term initiatives.
The challenges began in late 2020 with the last-minute suspension by Chinese regulators of Ant Group’s highly anticipated initial public offering. Since then, some of China’s largest technology companies have experienced unprecedented intervention from the Chinese government. This has led to significant volatility and indiscriminate sell-offs across the Chinese tech stock landscape.
No longer a slap on the wrist
Many of the businesses under scrutiny in 2021 had previously enjoyed years of unconstrained growth without significant oversight from Chinese regulators. However, based on plenty of recent evidence, the regulatory environment has changed dramatically. Penalties for anti-trust violations are no longer viewed as a slap on the wrist. We have seen record-breaking fines imposed on high-profile tech companies. Also, the compliance burden, particularly in data securities, has become so onerous that it is next to impossible for platform companies to list their shares on overseas exchanges. In extreme cases, such as in the after-school-tutoring industry, the entire business model has been overturned by new regulations.
The capital markets understandably went into a panic as these developments unfolded. Unsure of the government’s intentions and unable to fathom the risks of the next shoe dropping, many investors chose to step away from China’s tech stocks, with many describing them as “uninvestable.”
Short-term pain, long-term gains
Clearly, we are seeing structural changes in China’s industry policies and regulatory stance, especially within the technology sector. This has brought short-term pains, such as slower growth and/or increasing costs. But in our view, it is also creating long-term benefits such as a healthier competitive environment, higher ESG standards, and ultimately, more sustainable growth.
Many observers believe China’s authoritative decision-making process makes it difficult — if not impossible — to predict the government’s next move. We agree. But at the same time, we believe it is relatively easy to understand its long-term direction. This is because the government’s priorities tend to be consistent, well articulated, and long lasting. For example, earlier this year, the government announced it had achieved two key goals from prior decades — “eliminating extreme poverty” and “achieving moderate prosperity.”
In October 2020, the fifth plenary session of the 19th Central Committee cemented a new priority for the Communist Party of China — to achieve “common prosperity” by 2050. Zhejiang — one of the relatively well-off coastal provinces — was established as a model to achieve common prosperity by 2035. The new objective was a clear shift and one with specific numerical milestone goals that we believe will remain consistent.
We encourage investors to pay close attention to tech companies in strategically important areas where growth is still prioritized.
Internet companies may be poised to benefit
At the risk of oversimplifying it, “common prosperity” signals the central government’s priority shift from growth efficiency to fairness and sustainability. This is not aimed at the internet sector specifically. However, the intrinsic traits of the internet economy — winner takes all, market dominance, and lack of clear boundaries — certainly place the sector closer to the offending side in the eyes of the government.
Importantly, however, this is a priority shift, not a 180-degree turn. Growth is still vital for achieving the prosperity component of the goal, and the digital economy is only becoming more important to China’s growth formula. China’s internet companies will continue to be major contributors to — and beneficiaries of — these shifts, in our view. Broadly speaking, we believe Chinese internet companies offer attractive secular growth potential and continue to warrant investment allocations. However, their growth will be more measured going forward, particularly for the largest players. In this new environment, we believe some of the blue-sky scenarios will disappear and certain aggressive business practices will change.
We expect investors to adjust their numbers to value these companies under the new normal. Given continued negative headlines and lack of earnings upgrades, Chinese internet stocks lack short-term catalysts. However, after the recent sell-off, many are now trading at bargain multiples in the low teens on core earnings, suggesting a base-case scenario of no growth. This is far too punitive in our view. We believe these stocks should broadly outperform once investors digest the short-term impact. On an individual stock level, now more than ever, we believe the stock-picking framework should incorporate a regulatory angle — that is, how aligned a company is with the “common prosperity” objective.
Chinese tech is more than internet
We encourage investors to pay close attention to tech companies in strategically important areas where growth is still prioritized. These include semiconductors, 5G, artificial intelligence, Internet of Things, clean energy, electric vehicles (EV), and autonomous driving. In these areas, investors will find many different flavors of investment themes, all with what we believe will be the strong tailwinds of government support and sharply growing demand. For investors seeking global leaders, China’s tech space features the world’s largest EV battery maker, the world’s largest solar wafer and cell makers, and the world’s largest IoT platform and hardware maker. For believers of de-globalization and domestic replacement, we believe there are plenty of companies in the semiconductor and semiconductor equipment subsectors that offer strong, durable growth potential in large addressable markets. These stocks typically trade at high multiples, but the recent pullback across China’s tech sector has made them less expensive and has created especially attractive entry points, in our view.
Proceed with caution in certain areas
Investors should be selective in industries that concern people’s livelihood, as many business interests are not typically aligned with the government initiatives. Examples include health care, education, and housing.
For example, in the past decade, China’s after-school tutoring (AST) grew to a $100 billion industry, by far the largest in the world. Chinese AST companies prepare students for the gaokao — the national college admission test, long considered a playing-field leveler for those aspiring to move up the social ladder. The AST industry, however, alarmed regulators due to concerns that it created new social problems. Not only did it subject children to increasingly onerous workloads, but also it adds to the financial and emotional burdens of parents. This was potentially widening the gap between rich and poor, and suppressing already low birth rates. The government first stepped in with minor restrictions, such as fee caps and curriculum limits, but eventually decided to ban all for-profit AST companies.
Fortunately, in areas such as education, health care, and housing, technology companies are usually involved in an indirect way, such as digital transformation. Their own business cases may strengthen or weaken depending on their value propositions — growth versus cost efficiency, for example.
In our view, the structural changes in the investment landscape of China tech are driven by a major shift in China’s industry policies and economic priorities. We believe such changes don’t weaken the attractiveness of China tech stocks as an asset class, but they do require investors to look at the entire space with fresh eyes, adopting a China-centric mindset that considers the government’s priorities.
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