Opportunities to Earn Above-Average Returns Come When Investors are Worried
As measured by the MSCI FV Golden Dragon Index, the Chinese stock market fell 10% in July and a further 2.5% by late August. So far, this index is down 4.00% in 2021. This differs materially from the aggregate return of global stock markets as measured by the MSCI World Index, which have returned 15% so far in 2021.
The three largest Chinese technology companies, the TAMs (Ten Cent – Alibaba – Meituan), have been responsible for much of the weakness, having fallen more than 50% since February 2021. This performance compares to their FANG (Facebook – Amazon – Netflix – Google) counterparts in the US, whose aggregate shares price remains close to their all-time high.
To understand more about this situation, we have spoken to various managers of Chinese equity funds and attended a presentation by Lilian Li, a Chinese domiciled expert on Chinese policy and the technology sector in China.
This note summarises our findings.
What Happened in China?
The reason for the sell-off in Chinese technology shares and Chinese shares, in general, is rooted in the Chinese regime’s decade-old pursuit of “common prosperity”. The authorities have stopped “waiting and seeing” and, during 2021, have decisively imposed regulatory changes across strategic economic sectors to protect the Chinese consumer. These changes have materially impacted companies’ business models in the targeted technology and education industries, leading to foreign investor flight. Hence the fall in share prices.
Word on the street is that Chinese people support the changes. However, imposing them with scant regard for investors’ interests has caught investors off guard and sent a warning shot over the heads of those that were perhaps less aware of the risks of investing in China. Having said that, seasoned investors in China understand and accept the “regime risk”, although no investor enjoys it when these risks play out.
It’s not the regulations per se that have caused investor concern, but the Chinese style of applying regulation. Lilian Li’s recent tweet sums it up well:
China: Innovate then regulate.
Europe: Regulate then not innovate.
US: Innovate then not regulate.
Investors don’t like surprises.
The Ownership Issue
One potentially fatal risk is that of how foreign investors gain exposure to Chinese companies.
Foreigners (the US mainly) are not permitted to own shares in sensitive Chinese industries such as media, technology, and telecommunications. This rule means that Chinese companies cannot access foreign capital by listing on foreign stock markets. Twenty years ago, Chinese companies skirted this restriction by creating a structure called a Variable Interest Entity (VIE). Without going into its complexity, VIE structure allows Chinese companies to raise capital offshore by listing offshore. In turn, foreigners can get exposure to Chinese companies this way. However, the structure means that foreign shareholders have no ownership rights, but only rights to the economic benefits and all expected losses of the China-based business. If the Chinese government outlawed VIE structures tomorrow, these foreign listed entities would be worth zero.
As with every investment thesis, there are opposing sides. Some say that China is not investable; others say it presents a significant long-term opportunity at current prices. Some global fund managers will not invest in China; others have 30% of their emerging markets fund invested in China.
The investor’s job is to understand the risk and invest a portion of their portfolio in line with that risk. If the worst-case scenario does play out, it should not be catastrophic for the investor.
The Wellsfaber View
An investment in a Chinese equity fund will be volatile. There may well be periods where they deliver a return of -20% or worse. However, for long-term, patient investors, the view from Chinese onshore experts is that the opportunity at current levels is one well-worth taking.
Our view is that as emerging markets are fundamentally cheaper than developed markets, exposure could either be gained through a broad emerging markets fund with exposure to China, or through a Chinese equity fund as part of a properly diversified portfolio.
How to access the opportunity is a separate discussion.
“As for investing, as I see it the American and Chinese systems and markets both have opportunities and risks and are likely to compete with each other and diversify each other. Hence they both should be considered as important parts of one’s portfolio. I urge you to not misinterpret these sorts of moves as reversals of the trends that have existed for the last several decades and let that scare you away.” – Ray Dalio, 30th July 2021