Much has been written about the derating of the Chinese tech giants in response to recent aggressive initiatives from the Chinese state. The first signal was interference in the Ant Financial float, continuing through to its most recent actions in relation to ride hailing company Didi Chuxing post its IPO, and even more aggressively against the private education sector.
I claim no Chine expertise – in my hedge fund days, I invested in the region and at times it was an important part of the portfolios. I published a Forensic Accounting Report on five of their largest tech companies – Alibaba, TenCent, JD.com, Baidu and Meituan last summer. That report focused on how the companies presented their financial numbers, where we found multiple deficiencies, and did not address these wider issues.
The principal point we made on valuations was that the group had invested the equivalent of five Vision Funds in six years, primarily in tech in China. Now it’s a big market but arguably the Vision Find itself has had an impact on global tech valuations. It seemed implausible that you could invest five times that in a single market and not impact valuations. And we suggested there were potential consequences for some of the five.
But we had not anticipated (and were not asked to review) the Chinese Government action. Indeed we refused those elements of the original brief which covered local China issues as we are not experts. Now, however, with the drastic impact on several Chinese stock prices, I wanted to return to the issue and offer a few thoughts. Spoiler: there are no easy answers.
I think we need to consider the following issues:
1 The state’s objectives and how these companies fit in
2 China country risk
3 US attitude to China and implications
4 Investor protection
5 Level of uncertainty now and going forward
6 Have the stocks been adequately derated
1 STATE OBJECTIVES
I repeat that I am not a China expert and I no longer have access to the people on the ground on whom I formerly relied. I respect George Magnus, formerly of UBS, who writes extensively on China; he is a research associate at Oxford University’s China Centre and author of Red Flags: Why Xi’s China is in Jeopardy. To be honest, I haven’t read the book, but I have seem George present on it and discussed its conclusions with him; he is thoughtful and knowledgeable about China and his most recent article is worth reading, as is a piece for the FT.
Investors need to understand the objectives of state and party and how the tech and other companies can help achieve them. Of course, this is China so it’s not immediately obvious, but Magnus has highlighted and it has been widely reported that there is a renewed emphasis on social inequality. Imposing higher taxes on the wealthy would impact senior party officials and members and would be ineffective at helping the poor, given the sheer numbers.
There has already been some reaction within China. Zhang Weiying, an economics professor at Peking University, wrote that “Targeting rich people and entrepreneurs will only hurt jobs, consumers, charitable giving and lead the nation back into poverty” in an article published by the Chinese Economists 50 Forum, a think tank that includes some of the nation’s most prominent economists.
Higher income taxes and initiatives on inheritance and property taxes are likely, although there are probably too many vested interests, especially the municipal authorities, to do too much with the the latter, which is the engine of significant economic growth.
Corporates, however, may be an easier target. In the firing line so far have been Ant Financial which kicked off this trend and the wider tech sector (new laws affecting both are coming into force). Also targeted have been ride hailing (gig economy), private education (inequality), music streaming (frivolous) and gaming (potentially addictive, opium for the mind).
I guess the objective is to allow the incumbent tech giants, Alibaba in e-commerce, Tencent in gaming and music, Ant in payments, to continue to dominate, but less lucratively. Policies to curb their power will redistribute some of their markets and profits to smaller operators, merchants on their platforms, app developers, and to their customers and workers. The state will also likely seek to boost second-tier cities as tech hubs. The impact is hard to gauge.
First measurable impact was Tencent’s announcement that it will set aside 50 billion yuan ($7.7 billion, the first of two such payments) for a “common prosperity program,” a philanthropic initiative that provides aid in areas such as education, building out medical infrastructure and helping low-income communities.
“This new strategy of Tencent’s is a proactive answer to our nation’s strategy.”
Is this the end? Unlikely. 50 billion here, 50 billion there, it soon adds up. It might be 1-2% of the market cap but it’s close to 10% of revenue. That’s how we should measure it unless it’s a “one and done”. As I “went to press”, Alibaba announced a 100 billion donation over 5 years, over 10% of projected revenues. Bottom line: to understand the risk, you need to get inside the head of Xi Jinping. Not sure how easy that is.
One knock-on effect might be on the luxury sector – not sure how many SUVs Ferrari will sell if the Chinese decide that ostentatious consumption is out of fashion. Prada handbags, Louis Vuitton bags and clothing and many more could be affected.
2 CHINA COUNTRY RISK
Clearly the country risk has increased significantly and this merits some derating. An op-ed by George Soros in the FT was scathing about Xi, suggesting he “does not understand how markets operate” and that “he is putting in place an updated version of Mao Zedong’s party”. (One Twitter wit: “Surprising that the head of the communist party could be a communist”). Soros concluded that
“No investor has any experience of that China because there were no stock markets in Mao’s time. Hence the rude awakening that awaits them.”
Assuming that one accepts the risk, the question is how large a derating is required, and perhaps China was cheap before (disclosure: I bought A-share exposure as I considered the market cheap a couple of years ago). Higher risk implies some correction in share prices, although not the decline we have seen in some of these stocks.
That decline would be justified if there was a serious and enduring deterioration in the climate for Chinese companies. Soros clearly believes this and his vision is echoed by a Chinese blogger, Li Guangman, who wrote an article that revolution is underway in China. He is being taken seriously because the article appeared on dozens of official party and state websites. Li wrote that “China is undergoing a major change. From the economic sphere to the financial sphere, from the cultural sphere to the political sphere, a profound transformation is underway – or, one might say, a profound revolution.” Echoes of the Cultural Revolution perhaps, but that didn’t turn out well, and surely that lesson has been learned?
3 US ATTITUDE TO CHINA AND IMPLICATIONS
It would be easy in the circumstances to focus solely on the domestic issue and forget that the US has its own tensions with China. Investors must accept that the US attitude to China will likely become tougher under Biden and that the US quoted Chinese tech stocks are right in the crosshairs. If the US authorities want to exert minor pressure on China, the SEC is a possible route.
For example, the SEC could insist on proper audit supervision by the US: a potential consequence is ultimate delisting, which would cause a massive technical issue and share overhang. It’s not my central assumption, as the US want to maintain their stockmarket supremacy, but it’s perfectly possible – indeed, a well-known hedge fund manager, close to the Trump administration, told me that certain factions were keen to use this route. It’s hard to factor this into prices, as I discuss under uncertainty below.
Meanwhile, the Chinese state seems relaxed if US investors lose money as a result of its actions and conceivably might prefer these companies to be listed locally. US listed Chinese stocks have a collective market cap near $1.5tn, and the Nasdaq Golden Dragon China index which tracks them was down nearly 50% from the 2021 peak at one point.
The issue for the Americans is that retaliatory action would be inevitable and would likely be targeted at Apple which relies on China for almost all its manufacturing capacity and is its second biggest market – oddly in my view, there is nothing in its share price for this risk.
4 INVESTOR PROTECTION
Investors in these stocks have always needed to accept that the normal rule of law which operates in most markets is not applicable to China, for two reasons:
First, the VIE structures employed mean that investors’ legal rights are questionable (Kyle Bass has been particularly vocal on this). In the past, I dodged this by allowing the boss to make the judgment, but I never felt comfortable. Each individual will have a different perception of this risk and the required return as a consequence.
Second, in China, the state and party have ultimate control, which is why point 1 is so important and why you need real local expertise to invest there.
I claim no particular insight, but the VIE discount should be a more significant factor today. There has always been a risk that an investor in a VIE could end up with a zero. Recent actions by the Chinese authorities have certainly increased this risk. This may relatively benefit Hong Kong listed Tencent at the expense of Alibaba, JD.com and others.
5 LEVEL OF UNCERTAINTY NOW AND GOING FORWARD
Every stock has an element of uncertainty. One of my podcast guests explained that he thought this was a critical difference between a portfolio manager and an analyst. The analyst shuns uncertainty while the PM embraces it and asks if the price is right. Often uncertainty can provide an opportunity in stocks which is one reason why local knowledge can be so helpful. With greater uncertainty comes a wider range of possible outcomes. The interest expressed by China in the tech sector has shifted that range of outcomes to the left, and hence some derating of the sector is necessary, although calibrating that is extremely difficult.
Former valuations sometimes seemed to suggest near limitless upside for some of these stocks. Today, both the earnings potential and the multiple applied have been adversely affected. Scott Galloway suggests that
“This is a rare moment when beachfront property is going on sale. Xi may have rapped the knuckles of Jack Ma and the tech entrepreneur class, but it’s difficult to imagine he’ll cut off their fingers”
It may be beachfront property on sale but there is what looks like a tsunami on the horizon. Nervous investor sentiment is perfectly understandable and the state action may itself crimp growth; the Economist noted:
“…venture capitalists are already getting cold feet. Fundraising for privately held tech firms peaked at $28bn in the last quarter of 2020, when the techlash began, according to CB Insights, a data provider. In the second quarter of this year Chinese startups raised just $23bn, even as those in America raked in ever more capital”
Galloway is correct in pointing out that Xi needs economic growth to continue as the economic miracle is “only half-complete”. Tech stocks in particular benefit from very low tax rates; more charitable and social initiatives will also dent the bottom line. It’s inconceivable that these companies’ earnings power will not be lower; and it’s highly unlikely that investors will pay as much for that lower growth stream of cash flows given the risk of further action. One can argue that the fall has been overdone but a serious and likely permanent diminution in value has likely taken place.
6 HAVE THE STOCKS BEEN ADEQUATELY DERATED?
There has been a significant difference in the share price performance of the 5 stocks I reviewed in July 2020. Alibaba ($BABA) has fared by far the worst, hit first by the Ant Financial actions and the disappearance of Jack Ma, and suffering a second leg down this summer. Its performance compares badly to US peer Amazon. Is this enough? Charlie Munger thought so some months ago and to much fanfare. Valuation comparisons are fraught with danger, however, because the two companies report profit in a very different fashion, and much of Alibaba’s profits come from spurious revaluations of unlisted investments; these obviously need to be excluded but significant other adjustments are also required.
For the other companies, there is a range of outcomes – some are trading above their summer 2020 price but have fared less well than their US quoted peers. Again, valuations are often distorted by aggressive accounting and by the investment revaluations.
The recent bounce in some of these shares may be a dead cat bounce or may be a bottom. It’s probably early to predict which and much will depend on the activity of the Chinese state.
Predictions about these stocks clearly depend on the attitude of the China state. And I wonder if the recent share price action will make some investors feel unqualified to hold some of these stocks. In my view, it should, as the state interference may be a key driver for several years. My advice is to follow George Magnus and Michael Pettis as they have offered some useful insights in the past.
The action in respect of the education sector has been most aggressive and investors here have suffered the biggest losses. If a company is deemed a net negative to society in China, investors should expect to lose money.
The bears will argue that BABA et al have always been uninvestible and this proves their case. The bear argument goes along the lines of
Nobody has read the 1000+page BABA 10-K (shorter more recently).
The financials are meaningless anyway, given the number of acquisitions, the 800 subsidiaries and the financial chicanery.
You are partnering with the Chinese Communist Party.
You need to be a local to understand the Chinese politics.
The holders are taking comfort from the involvement of Munger and acolytes, without proper due diligence.
But if you believed that these share prices, notably BABA, were fairly valued prior to the Ant float announcement, you presumably would have to buy now. Here is the BABA chart, this in a climate which has been positive for markets and tech stocks in particular:
This is not an investment recommendation! Aswath Damodoran takes the view that Tencent is now cheap, and that the risk of greater Government interference is in the price: see his recent video.
My view is that it’s too early to tell and that stock selection is paramount. But the dead cat bounce could continue, if there is no further action from the authorities. And if Soros is right, the knock-on effects might be significant – not just on luxury manufacturers like Ferrari, Prada, LVMH and peers, but on US stocks like Apple (or even Tesla) with high China dependencies.
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