This week’s news flow has been dominated by China. Long time followers of my blog will know that China has long been a focal point. How can you not? It is the world’s second largest economy (largest on a PPP basis) and home to 1.4bn souls.
Even when I was down in South Africa, China occupied a large part of my focus mainly as South Africa’s export exposures as well as listed company exposures through the mining sectors as well as tech giants, Naspers/Prosus. A few years ago, I was also fortunate enough to be part of an investor trip to China meeting the heads of many of their large listed companies as well as regulators. It was a fascinating trip and I wrote about some of my learnings in this piece:
I would urge you to read the piece if you haven’t as I delved into some of the more nuanced cultural and strategic lens that regulators in China apply when considering regulatory interventions and this is ever more important given current developments.
A Wreck for Tech:
Recently, China has been grabbing the headlines for the wrong reasons. Chinese authorities over the last week announced several, seemingly sudden crackdowns on many of its tech, educational and property companies. This has resulted in massive pressure for many Chinese stocks, especially those listed in the US. I am invested in a variety of Chinese stocks and stocks with Chinese exposure and continue to hold them. I will not discuss stock specifics but rather try to share a different perspective to what you have seen in the mainstream.
For comparison purposes, the chart above looks at Hong Kong’s Hang Seng vs. the Nasdaq Golden Dragon China index. It’s not a like-for-like comparison as the NASDAQ index is largely tech focused whilst the Hang Seng is slightly more diversified. The point is illustrative. Over the last week, Chinese tech stocks have tanked and are down over 33% in the last 3 months.
However, as we like to do on Moe-Knows, it’s important that we zoom out further. Recent bans from the Chinese authorities prohibit online educational firms from making profit and compels them to register as Non—profits. Furthermore, no new licenses will be issued in this space. This kind of crackdown has not only decimated stocks in these sectors along with their parent companies (Like Tencent, Alibaba, etc) but also caused massive angst among international investors. But is this warranted?
Its about the collective
To unpack whether this squares with the Chinese government’s objectives, we have to understand what those objectives are. In the aforementioned article written in November, I highlighted themes like clean energy and the environment. There is also the importance of family dynamics and a more ‘holistic lifestyle’ which introduces touchpoints in education and healthcare.
It is vital to understand that the Chinese government sees all commercial activity in China as subsumed to the state and its wider societal objectives. They will allow the semblance or illusion of ‘free markets’ for as long as companies are aligned to the wider strategic initiatives of the Party and State. In this context, an investor in China must always realize that even as quasi equity holders (I will discuss VIE’s below), that they will ALWAYS rank behind the state and local players.
As an investor in Emerging Markets, this is not uncommon although it may be more implicit rather than explicit in some geographies. In short, it is par for the course.
As such, when applying an analytical lens to investing in China, it would be foolish to merely look at DCF’s, growth rates and valuations. It is imperative that one also try to ascertain to what extent a company (or even sector) one is invested in is achieving its wider societal aims.
It’s the the Five-Year Plan… get with the program
I doubt that there are many readers who have taken the time to delve into the China Five-Year Plan. I was fortunate the be taken through the previous plan by several high-profile Chinese businesspeople and some regulators. The most recent plan was launched in March this year and runs from 2021-2025.
The nice thing about the Chinese is that they have long planning cycles. Even the 5-year plan is part of a wider 30-50 year initiative to reshape and reframe China’s place in the world. The current plan maintains key aspects of a focus on the environment, financial reform, free trade zones, etc. It also doubles down on the qualitative aspects of people’s lives from healthcare to social security.
Quality over quantity, Self-reliance and gradual liberalization are all core to the messaging from the previous plan and carry over into the new. But there is also a newer dimension to the current plan. China is becoming more assertive.
For decades, the West was content with a China that stayed in its lane and tended to view China through a patriarchal lens. It was happy to benefit from low-cost Chinese labor and keeping the prices of our shiniest widgets down. ‘Designed in the USA, Assembled in China’.
China was similarly content to absorb billions of US dollars in export revenue and then investment. It was building up its own arsenal. But let’s not fool ourselves. This is a global ‘Game of Thrones’. The hegemonic frictions we now witness between the US and China were a long time coming.
An emboldened President Xi was given a global gap when former President Trump put the US onto a more isolationist path. At the time, Xi was championing the Paris Accord and multilateral cooperation in stark contrast to the US’s unilateral approach at that time.
This assertion is somewhat out of character of a naturally cautious Chinese cultural predisposition. But why now? China has seen President Xi consolidate his power in a way unlike any leader since Mao. This has meant that his control over China’s political structure has tightened. Xi feels emboldened to take China to the next step globally. Truly, the Dragon has awoken.
With great power comes great responsibility
President Xi also knows that as he continues to build his power internally, that more responsibility will vest in him personally. This means that any civil, economic or societal unrest will likely come with great personal consequences. It’s an all-in scenario for him.
Part of the longer term plan contains some of the ‘Kissinger-esque’ strategy of the US of yesteryear. They contain elements of projecting China’s cultural soft power. The concept of ‘soft power’ is one which US foreign policy espoused for many decades before being thrown out with the bath water in the last administration.
China has learnt and in some respects is emulating the path that the US followed to global greatness. This is a point of friction and may prove quite testy. Recent diplomatic discussions between Beijing and Washington have been less than friendly with the Chinese cautioning the US against antagonizing it further.
Geopolitics aside, it is probably too late for the US who was caught sleepwalking into this to arrest China’s rise. A more prudent strategy would be to ‘contain’ the issue as much as they can…and quite frankly even that is questionable.
In this construct, issues around Hong Kong and Taiwan are not likely to go away. Instead, the more emboldened the Chinese become, the higher the regional and global temperature check.
Reading the tea leaves
China recently announced an evolution of its 2-child policy into a 3 child policy. I wrote a piece about it here:
It is key to highlight that the recent moves by authorities are in direct response to what the authorities perceive to be threats to its objectives of a holistic wellbeing, family structures and more.
Education in China is fiercely competitive. Children are pushed hard to succeed. The cost of additional educational resources is a threat to a more egalitarian access to resources. This is potentially the flash point in this regulatory foray. That said, as I have written before, China’s regulatory approach is 2 steps forward and one back.
This is endemic to a cultural caution which is the anathema to Western ideals of assertion. But make no mistake, China is moving forward. This perceived step backward is part of a longer term playbook as China calibrates regulation to ensure it stays on track with its strategic plan.
Lowering educational costs and pressures on children may well also play into encouraging Chinese into having more children, a task which has thus far proven difficult.
I have highlighted above, how and why I think a long term lens on China is critical. For the long term investor, it may be a bumpy ride but understanding China and the nuance is vital.
For me, China is too large to ignore. The opportunity is tremendous. That said, when I do not understand the regulatory backdrop, rather than cutting and running like many are doing now, I look at whether I believe the companies I invest in are achieving the long term Chinese objectives.
I am also acutely aware that unless I own Chinese A or B shares (via a QFII or RQFII programme) that I am likely holding a financial instrument rather than actual equity or stock in a Chinese company. I know this. Most US listed ‘Chinese stocks’ are Variable interest entities (VIE’s) and many investors are only waking up to this risk now. Click on the link to familiarize yourself if you aren’t already. VIE holders have no voting rights and their economic right is contingent on agreements of profit share.
If you are not familiar with VIE’s , QFII an RQFII, and you’re serious about investing in China, please do your research. Similarly, China’s play for Hong Kong may well also likely be grounded in its need to deepen its own financial and capital markets. So keep an eye out for developments there.
The US listing flashpoint will be quite critical and I will watch US-Sino relations closely as this represents a key risk. VIE’s are vulnerable…
That said, China would not likely antagonize the international investor community ad-infinitum. It is flexing its muscle and once done, will likely provide an avenue for international capital to participate. Perhaps on its own terms and via Hong Kong or some other structure. But the rules of the game may change and change is painful.
For now, I am cautious but I am holding on to what I believe are good long term investments…. And I remain somewhat of a Bull in a China shop.
These blog posts are commentary. There is ALOT more beneath the surface.
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