A rather long essay on China but worth the read for those interested in China
happenings.
Bob Kasprak===============================
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div.yiv1187520079preheader {display:none !important;}Investing in China has
changed forever.
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Think It Will All Blow Over for Chinese Tech? Think Again...
By Kim Iskyan
News flash: Chinese capitalism has about as much in common with Uncle Sam's
vision of the free market as Chinese takeout at your local strip mall does with
what they call "food" in, you know, China. In other words... it passes a vague
resemblance – but that's it. That the rules of capitalism of the Chinese
Communist Party ("CCP") are in fact very different was a $1.5 trillion lesson
for investors this year in the shares of a wide swath of Chinese tech
companies. (Bloomberg reported last week that's how much market value has been
destroyed in Chinese tech shares since February.) That amount of money is
comparable to the GDP of Russia... or about 8% of the market capitalization of
the Nasdaq 100. The Nasdaq Golden Dragon China Index, which tracks the share
prices of the biggest Chinese companies listed in the U.S., is down 44% from
all-time highs in February. Online e-commerce giant Alibaba – which in the
first quarter of the year was the eighth-largest publicly traded company in the
world – is down 37%. The education-technology sector, not long ago worth $100
billion, is now at around one-fifth its previous highs. It's a bloodbath... And
it's changed things for investing in China – forever.
The CCP's Tech Offensive
The winds of change started to blow in November, when the Chinese government
abruptly halted the highly anticipated initial public offering ("IPO") of Ant
Group, a fintech giant, and then forced it to completely change its business
model. Within months, Alibaba, gaming and entertainment giant Tencent (peak
market cap in February: $950 billion), and three dozen other Internet companies
were targeted by China's antitrust regulators. Many were fined (Alibaba was hit
with a $2.8 billion penalty) or otherwise penalized for misleading marketing
tactics, not disclosing corporate actions like mergers, signing contracts that
were exclusive and anti-competitive, and other transgressions. Early last month
– less than two days after a splashy New York Stock Exchange IPO that raised
$4.4 billion – Chinese ride-hailing service Didi Global was charged with
violating data-security rules. The shares were recently down more than 50% from
their post-IPO highs. And the (latest) icing on the cake was the
education-technology sector, where new rules barred companies that teach topics
or subjects which are part of the school curriculum from making profits (so
much for capitalism)... or listing abroad... or having foreign investors.
Broadly speaking, the CCP has cracked down on technology companies for
antitrust violations (that is, for doing things that disrupt natural
competition between companies)... data security violations... and what China
analysis service SupChina calls "growing pains from 'disorderly capital
expansion.'" That's a big tent for what's best interpreted as "growth at the
expense of the public interest." In other words... when capitalism and the
public good collide, the former (and its investors) gets taken out back by the
CCP and spanked within a breath of its life.
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What Is the Chinese Government Afraid Of?
Like a five-year-old alone in the dark, the Chinese government is afraid of
everything. It's concerned about instability and social unrest – perhaps
stemming from the rising cost of living, real estate, education, and anything
else where the profit motive impinges on people... and increasing levels of
unemployment as economic growth slows. It's afraid of competition for power
from too-big-for-their-britches billionaires who are accumulating too much data
– as well as from foreign influence, via private companies or when those laowai
(slang for "foreigners") get their hands on data itself. Oh, and it doesn't
want the kids to spend too much time glued to screens. (OK, this one at least
has some merit.) Ultimately, the CCP – and, more specifically, Chinese
President-for-as-long-as-he-feels-like-it (following the removal of
presidential term limits in 2018) Xi Jinping – craves power. As Bruce Bueno de
Mesquita and Alastair Smith explain in the political science classic The
Dictator's Handbook...
Any leader worth her salt wants as much power as she can get, and to keep it
for as long as possible. Managing [various political constituencies] to that
end is the act, art and science of governing.
The CCP knows that it has to keep just enough Chinese people just happy and
content enough so that they don't try to disrupt the status quo. It's already
clear that it's not afraid of lying to its own people. And the
2.2-million-strong armed forces... upwards of 350 million surveillance
cameras... proven genocidal tendencies (against the Uyghurs in Xinjiang
province)... and a demonstrated willingness to murder its own people on a world
stage (the Tiananmen Square Massacre was only three decades ago)... can keep
the lid on things for a while (and maybe even decades, or generations) – but
not forever. As SupChina explains, one of the biggest reasons for China's tech
crackdown is that "public disenchantment has reached a boiling point"...
[In some cases] it's clear the Chinese government is responsive to broader
social disenchantment. Recently, dissatisfaction with parts of the status quo
has again reached a fever pitch, ranging from frustration over the "rat race"
of education to the cost of housing... These worries may have forced Beijing's
hand [in part through] "tough-on-business regulations"...
This Is Structural Change
There are (at least) two paths of evolution. Most changes are cyclical...
Seasons, markets, and moods nearly all of the time move in cycles. And it's
easy to dismiss the recent Chinese government obsession with clawing back
influence from the tech sector as just a bump on the road to, say, Tencent's
steady march toward a $2 trillion valuation... Didi running over Uber... and
Alibaba threatening Amazon's perch. But very occasionally, the cycle itself
changes. And this looks like a structural shift... similar to when climate
change means that the cycle of seasons no longer applies. Investors are always
warned about the downside of believing that "it's different this time" (usually
uttered at the peak of a bull market in reference to valuations not mattering
any more, or some such bubble nonsense). And this time, the fact that it's
different is a bad thing for investors.
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Can't Someone Do... Something?
But wait... President Jinping can't just – poof, with a wave of the sorcerer's
wand – erase entire sectors... can he? Actually... yes, he can. The measures
that have kneecapped China's tech sector in recent months were edicts that
weren't subject to filibusters or backroom political horse-trading or
complicated electoral calculus. It's like rubbing the genie's lamp – only
there's no cap on the number of wishes, and the guy with the shiny lamp doesn't
care what anyone else thinks or what happens to your Chinese-stock-laden
401(k). As emerging and frontier market broker Tellimer explains...
What makes Chinese capitalism so different is the speed with which the
government can so comprehensively change regulatory policy without any change
in the government itself.
Hang on, though... Even if the Chinese government can, say, make Thursday
opposite day, or force everyone to wear brown socks with their blue suits, or
do whatever else it wants... surely (foreign) shareholders of China's companies
will be able to do something, right? Chinese companies have raised upwards of
$13 billion on U.S. exchanges this year so far, according to the Economist. As
of early May, according to the U.S.-China Economic and Security Review
Commission, 248 Chinese companies were listed on U.S. exchanges, with a total
market capitalization of $2.2 trillion. All that investment must be worth...
something, in terms of having a say.
Shareholders Are Shushed
Bad news here, too (welcome, again, to Chinese capitalism). As the Economist
explains...
Nearly all Chinese tech giants listed in America... use... "variable-interest
entities" (VIEs). A VIE is domiciled in a tax haven like the Cayman Islands,
and accepts foreigners as investors. It then sets up a subsidiary in China,
which receives a share of the profits of the Chinese firm using the structure.
China's government has long implicitly supported this tenuous arrangement, upon
which hundreds of billions of dollars of American investments rely.
In other words... There's an argument to be made that foreign shareholders of
big Chinese companies hold a big nothingburger – or rather, something that's
worth something only if President Jinping decides it's worth something. (And
guess what: VIEs – which exist to help Chinese companies get around limits on
foreign ownership – are likely going to come under regulatory scrutiny. If you
thought the Chinese tech meltdown was bad so far, hold my beer.) Mind you... an
excessive concentration of power at tech companies is hardly unique to China.
For example, Facebook CEO and co-founder Mark Zuckerberg owns around 13% of the
company's shares but controls 60% of the voting rights. The two founders of
Robinhood own about 16% of the shares, but together control 65.2% of the
company's voting power. It's the same story with dozens of American tech
companies. Would you rather have a few millennials controlling big, powerful
technology companies – or the Chinese government? The jury might be out on that
one... But here, clearly Chinese capitalism and the American flavor have more
in common than you might think.
Welcome to the 'China Discount'
Few investors are under the illusion that China is a developed market. In
emerging markets, politics – rather than economic fundamentals or the business
environment or company dynamics – are the key driver of stock markets and share
prices... and that sounds a lot like China just now. Emerging markets are seen
as a lot less predictable than developed markets and a lot riskier. So for
years, emerging markets have traded at a lower valuation than developed
markets. One of the best ways of measuring market valuations is to use the
cyclically adjusted price-to-earnings ("CAPE") ratio. It's a longer-term,
inflation-adjusted measure that compares the price-to-earnings ratio we all
know and love with short-term earnings and cycle volatilities to give a more
comprehensive and accurate measure of market value. Today, developed markets
trade at an average CAPE of 24, compared with a CAPE of 15 for emerging
markets. China's stock market is at 18 – on the expensive end of the emerging
markets spectrum, but not terribly so. (U.S. markets trade at a nosebleed CAPE
of 38.) The problem, though, is if the heightened uncertainty in the Chinese
market causes investors to place a valuation discount on the country's stock
market. Xi Jinping can destroy entire sectors of the stock market in the time
it takes you to brush your teeth. To "compensate" for that level of insecurity,
investors might demand a lower valuation for Chinese shares. What does that
mean? Let's say I'm buying an apartment off the plan (that is, before it's been
built), by a developer I've never heard of, in a sketchy neighborhood. Because
it's a risky proposition, I'll want to pay a lot less per square foot than if I
was buying a ready-to-move-in apartment from a highly regarded builder in one
of the best parts of town. And right now, China is looking like a big hole in
the ground by Trust Us Developers on the wrong side of the tracks, and the
cashier is using a shoebox. Valuations fall when earnings rise – or the price
falls. If China's markets were to be valued below the average of emerging
markets – say, closer to a political risk like black hole Russia (which has a
CAPE of 8), rather than the current level that's more than twice that – share
prices would need to fall more than 50%. (That's assuming no change in
earnings.) Of course, markets don't re-rate overnight. And China's market could
settle closer to a CAPE of, say, 14 rather than lower. But China's tech sector
has been steadily re-rating since February (remember that $1.5 trillion?). And
the risk is that with this structural change, China's tech valuations will be
permanently lower because investors are anticipating that a
woke-up-on-the-wrong-side-of-the-bed Xi Jinping will take out a sector or two
before breakfast.
Who's Next?
Who could have known what was coming down the pike for China's
education-technology sector? It turns out that all you had to do was listen to
the man. President Jinping told the world his plans for this sector – but no
one was listening. Bloomberg explained a few days ago that in mid-June, China's
president was...
Holding court at an after-school club for elementary students in the remote
city of Xining. Acknowledging the growing pressure on students and their
parents to spend time and money on private tutoring, Xi promised to ease their
burden. "We must not have out-of-school tutors doing things in place of
teachers," he said. "Now, the education departments are rectifying this." Xi's
comments went largely unnoticed by global investors at the time...
So what's next on Jinping's hit list? Bloomberg reported earlier this week
that traders "began scouring databases and other collections of Xi's speeches
to find clues about which industries might be next after." SupChina suggests
that "sectors that are highly concentrated, have little relation to state
priorities, and have previously become targets of public scrutiny" are
blacklist possibilities. For example... the gaming industry. There are two big
players, one of which is Tencent. The time-wasting of gaming is anathema to
China's state priorities... And the government has in recent years tightened
the regulatory noose on the industry. For example, in November 2019, gamers
under 18 were banned from playing online between 10 p.m. and 8 a.m. and were
limited to 90 minutes of gaming on weekdays (and three hours on holidays and
weekends). (Such a measure would have caused serious social unrest in my own
household, spearheaded by my 15-year-old Fortnite champion son.) Unhelpfully, a
state-linked media organization earlier this week labeled the gaming industry
"spiritual opium"... which is like your mom labeling your Cap'n Crunch cereal
as "too sugary" – moments before she removed the box from the shopping cart and
returned it to the grocery shelf. Real estate might also be on the chopping
board, SupChina explains...
China has increased scrutiny on the real estate industry, long marked as an
industry needing reform as Chinese families identify the cost of housing, along
with education, as a major pain point. Property prices have been shown to
exacerbate social inequality.
Could It Happen Here?
For all of its warts, one of the good things about the American brand of
capitalism (aside from its lousy Chinese food) is that it's difficult to upend
entire sectors of the economy or market on the basis of a presidential whim.
(President Trump tried to KO a few companies... Jeff Bezos' Amazon is still
going strong, though.) Regulation of the technology sector is barely happening.
Applying a hammer – even if it's just a knee-reflex one – to some of the
democracy-destroying monopolists of the American tech industry (hello there,
Facebook) is preceded by years of congressional dithering and hand-wringing
about regulatory overstep.
There's a Price for Everything
Does what's happening in China mean that you should never buy a Chinese stock
again? Of course not... There's a price for everything – the point at which
risk is priced in. In the timeless words of value investing grandfather
Benjamin Graham, "Although there are good and bad companies, there is no such
thing as a good stock; there are only good stock prices, which come and go." In
other words... There's a price (and P/E) at which Alibaba is a great buy – and
the risk that President Jinping will pull out a new instrument from his
financial-markets torture kit is mostly reflected. Right now, Alibaba is
growing about as fast as Amazon – but it's valued at a P/E of 20, compared with
52 for Amazon. At what point does Alibaba, or any other survivors of the hot
mess that's Chinese tech, become a buy? Sometime soon.... if you can handle the
risk that there's more to come. And in light of the structural changes in the
government's approach to regulation – of tech, and of capitalism – don't expect
share prices to bounce back... It's a new world for investing in China.
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Read our latest issues of American Consequences. Love us? Hate us? Let us know
at feedback@xxxxxxxxxxxxxxxxxxxxxxxx. Regards, Kim Iskyan
Executive Editor, American Consequences
With Editorial Staff
August 6, 2021 |
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Infringements can be punishable by up to five years in prison and $250,000 in
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