Recent regulatory action around China’s after-school education companies has raised concerns around the country’s economic system. The companies had been stock market darlings, propelled by strong demand from parents looking to get their children ahead in a competitive education system. But new regulation has effectively made the sector non-profit, shrinking the addressable market for these companies from $100 billion to $25 billion2 and wiping billions off the market caps of education companies such as New Oriental and TAL Education (Figure 1). This was a worst-case scenario few investors had been anticipating.
Figure 1: The political and financial stance of successive administrations
Source: Bloomberg, as at 13 August 2021
This may one day be considered a watershed moment in China’s market history. The prioritisation of quality rather than quantity of growth has become increasingly important to the Chinese government, and one metric it wants to address is the rise in social inequality, especially in the three areas of deepest concern to the middle class: education, housing and healthcare. Highly profitable private, after-school education companies, at which families spent 7%-9% of their household incomes in 20173, are unlikely to be looked upon favourably under this new regime.
At the same time, new regulation has also been the source of market volatility for China’s big tech giants. Companies such as Alibaba and Tencent have been at the forefront of China’s new economy for the past decade, spearheading the digitisation of the country’s economy with technology ecosystems to challenge those of the leading US tech peers. Successful innovation and exponential growth meant that, at the February peak, internet companies made up nearly half of the MSCI China index.5
China has a history of letting industries experiment in early stages to help supercharge growth and regulating after the fact as challenges emerge. It is now the turn of the tech stocks. Many of the challenges regulators are seeking to tackle are the same as those facing US companies – antitrust, data security and workers’ rights. In the case of big tech, it is highly likely the Chinese government realises it actually needs for-profit companies to achieve another of its policy objectives: that of greater technological self-sufficiency, an objective that has become ever more urgent since former US president Trump began his technology-focused China containment policies in 2018. Beijing still wants tech companies to thrive, but more in ways that meets its policy objectives.
How will markets be affected?
This takes us on to the market impact of these moves, with many participants asking if the new policy regime makes China uninvestable? Recent murmurings from government officials suggest a continued commitment to market-based principles, with extreme for-profit bans likely to be limited to the education sector. Nevertheless, it is reasonable to expect continued policy action in other areas as regulators attempt to interpret and implement the government’s new focus on technological self-sufficiency, decarbonisation and reducing social inequality.
Once again, the Chinese economy is evolving, and companies that are in areas under scrutiny will need to change their business models – it is uncertain what type of earnings profile these companies will have in the next three to five years. With such uncertainty affecting more than 40% of China’s equity market, the multiples investors are willing to pay for Chinese stocks will be lower. As a result, we have exited all our positions in Tencent, having held the stock for many years.
We must not forget, however, that China is the second largest economy in the world and growth opportunities remain, even as the economic regime evolves. Some of our portfolio companies, which are listed elsewhere, have significant exposure to China and we remain optimistic about their growth prospects, especially where revenues are aligned to new policy objectives. For example, China’s plans to decarbonise will be a likely boon for electric vehicle manufacturers, and in turn as a supplier our holding TE Connectivity, which derives a fifth of its revenues from the country. Similarly, the flip side of the government’s ban on after-school tutoring has been the announcement of new policies to promote greater participation in sports, which should benefit another of our holdings, Adidas, for which China accounts for a quarter of sales.
More opportunities will present themselves with time, but we prefer to wait until the policy picture becomes clearer.
For an extended viewpoint version of this blogpost, with additional data and more detailed discussion, click here: Cats, rivers & regulation: the lowdown on Chinese equities.