August 6, 2021
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.
This top tech investor now predicts a reset, but it’s not what most Americans expect. Get the full story here.
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.
I’m not sure if you remember books, America, but it’s what people used to sink their faces into to avoid dealing with family and strangers. Our editor-in-chief, P.J. O’Rourke, has written a few in his time, and he’s re-releasing his bestselling Eat the Rich, complete with a new chapter to take on the absurdity of 2021 economics. And as an American Consequences subscriber, you can have access to the newly released edition for free! Claim Your Copy Now.
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 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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August 6, 2021