China Changes

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.

CONCLUSIONS

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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