Investors Are Running Scared From China’s Stocks. Where to Find Opportunities.
By Reshma Kapadia
Illustration by Justin MetzIt has been a rough year for investors in China, especially those who forgot that it’s still a Communist nation with a government that can act unilaterally and change direction swiftly and ruthlessly.
After some surprising, and very anticapitalist, moves in the past several months, Chinese stocks are plummeting.
China’s market is down 20% in the past six months, while some of its biggest names have dropped more than 40%.
Has China become uninvestible?
No—but it has gotten a lot more complicated.
U.S. investors have largely focused on China’s tech giants, but given the situation today, there are better options.
For years, the Chinese government allowed—even assisted—internet companies, enabling them to blossom with little intervention.
This created lucrative returns for investors and helped the nation mint more billionaires—257—last year than any other country.
Investors became less wary, even complacent, as the world’s second-largest economy seemed to be embracing capitalism.
That narrative has been unraveling.
As President Xi Jinping makes an expected bid for a third term next year, he is trying to strengthen his grip on the Communist Party and address public discontent.
That has led to a policy shift toward “common prosperity,” emphasizing social welfare and national security, and regulation that targets swaths of the economy, including the technology, education, property, and healthcare industries, and many of China’s most well-known and successful companies.
Illustration by Justin Metz
The moves have not been small: The Chinese government blocked the highly anticipated public offering of Alibaba Group Holding (ticker: BABA) affiliate Ant Group last fall, overhauled the fintech’s business model, and dealt a public rebuke to outspoken founder Jack Ma.
Beijing also targeted soaring education costs by turning after-school tutoring firms into nonprofits.
And it cooled a hot initial-public-offering market with an inquiry into the data practices of DiDi Global (DIDI) just days after it went ahead with its U.S. market debut—and chilled it further on Friday with plans to ban user data-heavy companies from seeking IPOs in the U.S., according to The Wall Street Journal.
All served as a stark reminder of who is ultimately in control in China, and the risks to investors.
The pace, breadth, and uncoordinated nature of the measures coming from various regulators have been jarring, causing China enthusiasts like Stephen Roach, former chairman of Morgan Stanley Asia and a senior fellow at Yale University, to reassess his favorable view on China. “I stuck with it because fundamentals are impressive and strong,” he says. “This is a warning shot on that view.” His main concern: New regulations and increased scrutiny could stifle the “animal spirits” needed to help fuel innovation and keep China’s economy growing.
Investors are running scared. The KraneShares CSI China Internet exchange-traded fund (KWEB) has lost 45% in the past six months, with Alibaba down 30% and education companies like New Oriental Education & Technology (EDU) and Tal Education (TAL) down about 90% in the same period. In the first two weeks of August alone, investors yanked $3 billion out of China, according to EPFR Global.
Investors should be greedy when others are fearful, according to a Warren Buffett adage, and there is a lot of fear reflected in Chinese stock prices, even as some intrepid investors have gone back in.
China is a $15 trillion economy, home to 1.4 billion people and myriad innovative companies—long-term investors cannot ignore it. But they shouldn’t ignore the multitude of risks, either.
So what’s an investor to do?
First, understand the risks.
Then, there are two ways to approach investing in China today—smaller companies, best owned through a mutual fund, and knowing when to go into some of the nation’s biggest names.
The Risks: What to Watch
When the two most powerful economies clash, the risks are plentiful.
Let’s take the U.S. first: There’s bipartisan support for a tougher stance against human-rights abuses, and a broader desire for increased scrutiny of Chinese companies listed as American depositary receipts, or ADRs.
The Securities and Exchange Commission is looking at ways to take steps that pave the way for delisting Chinese companies that don’t comply with U.S. auditing standards.
SEC Chairman Gary Gensler has warned that many U.S. investors aren’t aware of the risks embedded in Chinese ADRs.
This is because of a complex corporate structure called a variable interest entity, or VIE, that’s used to skirt China’s foreign ownership rules and results in U.S. investors owning shares in a shell company with a contract with the Chinese business operators.
Even professional money managers have increasingly dumped Chinese ADRs in exchange for shares listed in Hong Kong; large-cap funds have half the exposure to Chinese ADRs today that they did two years ago, according to Bank of America.
Then there’s China.
There are the “all bets are off”–type risks, like a conflict with Taiwan, that could destabilize global markets.
More immediately, there are the risks that come with investing in an authoritarian government that is tightening control over business and society.
Xi is clearly emphasizing a need to address the wealth inequality created by recent economic gains, even at the expense of corporate profitability.
China has taken a heavy hand to regulation before, including an anticorruption drive that hit luxury and casino stocks hard in 2012 to 2014 and a crackdown on the online-gaming industry in 2017, but this drive is much broader and less coordinated—driven by different types of regulators, and it shows little signs of wrapping up.
“The regulation doesn’t have a framework you can latch on to,” says Ruchir Sharma, chief global strategist at Morgan Stanley Investment Management.
“It’s disorienting.”
China passed some of the world’s strictest data-privacy laws this month and is targeting anticompetitive behavior, like internet behemoths’ exclusivity agreements with small merchants and algorithms that can influence consumer behavior.
Regulators have pushed e-commerce companies to raise compensation for gig workers and are exerting more control over content and entertainment.
Also on the table: possibly eliminating the preferential tax treatment that internet companies have enjoyed and increasing pressure on businesses and the wealthy to give back more to society.
Over the long term, some of these regulations could mean more sustainable growth in the internet sector, which has been the scene of price wars, subsidies, and misdirected investments.
But in the near term, “this marks a sea change, and is triggering a reassessment by investors of some of the big companies,” says Rajiv Jain, chief investment officer of GQG Partners, whose emerging markets strategy is underweight China.
“ China Mobile used to trade at 40 times earnings, and every investor wanted to own it,” he says, “but as it got hit by regulatory pressure over the years, it dropped significantly—even before the implementation of regulatory sanctions” that led to its delisting.
A government-owned entity just took a stake in ByteDance, which owns TikTok, raising questions about how much political intervention investors should expect—and whether China should trade at a discount to other emerging markets, as Russia does.
But China isn’t Russia; its size and breadth of market opportunities are far larger.
Plus, innovation is crucial to China’s ambitions to reduce its dependence on the U.S., which is why even those wary about the recent moves do not expect China to devastate its internet behemoths, which are a hotbed for emerging technologies like artificial intelligence.
With the private sector accounting for almost 90% of urban employment and the digital economy accounting for 40% of China’s gross domestic product, most expect China to ease off or reverse course if its efforts begin to impinge on growth at a time when the economy is already slowing and as another round of Covid-19 restrictions hit.
In fact, the People’s Bank of China has already been trying to ease strain on small and medium-size enterprises and said it would boost the amount of money flowing to smaller businesses and the economy.
As the Communist Party grapples with inequality, corporate profits may not be as juicy, but they won’t disappear.
And China isn’t done with its experiment with capitalism.
“In the long term, you can’t ignore China—and they do want foreign investment,” says Mark Mobius, a veteran emerging markets investor who now runs Mobius Capital Partners.
He adds that the recent panic-fueled selloff has made China more attractive.
“They want to become very powerful, and the only way to do that is by having a successful market economy.”
Underpinning all of this is a larger objective: to become more independent in a world turning increasingly hostile to China.
That means China is intent on creating a deep and liquid capital market, one more accessible to domestic investors, who have not been able to access offshore companies like Alibaba and Tencent Holdings (700.Hong Kong).
“China is far from over,” says Justin Leverenz, manager of the $50 billion Invesco Developing Markets fund (ODMAX), which is underweight China’s megacap technology stocks and investing elsewhere in the country.
“The bull case is very strong—and not incumbent on foreign investment.
There will be a multiyear transformation of the asset allocation of the households in China that drive prices. Why would one not be part of this explosive opportunity?”
The Strategy: What to Buy
Beijing’s policy shifts and regulatory efforts are reshaping industries, which puts the behemoths—such as Alibaba, Tencent, and Yum China Holdings (9987.Hong Kong)—at risk of slower growth and crimped profitability in the near term, but opens up opportunities elsewhere, notably companies in areas like renewable energy, autonomous driving, hardware, and businesses helping to create a stronger middle-class.
These lesser-known companies—some big, just not giant, as well as smaller firms—are not as well represented in broad market indexes and are best owned through mutual funds with experienced managers who understand the changing dynamics.
Investing with funds also allows individuals to sidestep logistical issues, like delistings, and is an easier way to access Hong Kong–traded shares and the vast onshore, or A-shares, Chinese market.
For a China-focused option, the $1.6 billion Matthews China (MCHFX), down 2% this year, has a strong long-term record, and lead manager Andrew Mattock sees opportunities not just in the internet platform companies but also in domestic software and hardware companies, consumer-oriented companies, and those that are part of the value chain for renewable energy and solar—two areas that the government is intently focused on bolstering.
Some of the best emerging markets funds have invested in China without overloading on its behemoths.
The all-cap $147 million Wasatch Emerging Markets Select (WAESX), which has returned 19% this year to beat 97% of its peers, has been underweight China and veering toward smaller companies within the country, some of which could benefit as Beijing stresses social good over profits.
“Very large and very successful companies may have reached the limits [of profitability], so you may be better off in smaller companies that can go unnoticed,” says lead manager Ajay Krishnan, who owns Chailease Holding (5871.Taiwan), a Taiwanese company that provides financing to the small and medium enterprises that Beijing is trying to bolster, and chip maker Silergy (6415.Taiwan), since China is trying to reduce its dependence on the U.S. for the key input for advanced technologies.
The $2.1 billion Seafarer Overseas Growth and Income fund (SIGIX), which is up 4.8% this year, beating two-thirds of its peers, has been underweight China.
But Andrew Foster, a longtime Asia investor, says the selloff has made China more investible than in the past five years because the market can no longer ignore the risk of investing in state-controlled companies.
Foster has gravitated toward companies that are not against or aligned with China’s policy agenda, like drugmaker Jiangsu Hengrui Medicine (600276.China), which has a stable of oncology treatments, including one for liver cancer that’s up for U.S. Food and Drug Administration review and could help the company go global.
The Strategy: When to Buy
China’s most well-known companies are starting to look cheap to some U.S. investors, though the likelihood of volatility means there will be ample opportunity to buy. These three are among the ones to watch.
Alibaba
One of the world’s largest online retailer is also home to China’s dominant cloud computing business, and myriad others.
Before the derailment of Ant’s IPO last fall, it traded at 30 times earnings; today, it’s closer to 15 times next year’s earnings, and has $73 billion in cash.
That’s a fraction of what Amazon. com trades at, even though the two e-commerce giants both earned about $22 billion in fiscal 2020—and Alibaba’s sales are growing faster.
Of course, Alibaba (9988.Hong Kong) operates in a country with an ambiguous rule of law, so some discount is warranted.
But at less than a third of Amazon’s market value, the discount may be at an extreme—even if its profitability and growth prospects are lighter.
“Alibaba controls almost half of the e-commerce in the country and is at the center of making sure China has a vibrant economy moving from manufacturing to consumption,” says Victor Liu, senior research analyst at Causeway, who expects midteens earnings growth over the longer run.
“This is still a company that has a lot of growth in front of it, just not as unbridled as before.”
There are company-specific risks that have nothing to do with China’s political efforts: Competitive pressure has been intensifying, and Alibaba’s aggressive investments to catch up with younger rivals like Meituan (3690.Hong Kong) and Pinduoduo (PDD) depressed near-term earnings growth prospects.
The mean analyst estimate on FactSet for earnings per share in fiscal 2022 is now $9.50, down from $12.34 at the beginning of the year; analysts expect sales to rise 29%, to $143 billion, for the fiscal year ending next March.
Ironically, Beijing’s antimonopoly measures could force more discipline in Alibaba’s investments.
The company also just increased its share buybacks to $15 billion from $10 billion.
Alibaba’s stock is used as a proxy for China, and it has the most risk and the most issues with its business model—all of which will keep the stock volatile.
But if it drops another 25%, where its price/earnings ratio is in the low teens, even wary money managers say they would bite.
Tencent
Tencent, which has fallen 30% in the past six months, is more appealing.
The company’s core mobile-gaming business is under less competitive threat than Alibaba’s core business, and CEO Pony Ma has a better history of keeping a low profile and staying in the good graces of Beijing.
Unlike Alibaba and other big internet companies, Tencent, whose WeChat app has more than a billion users, never listed in the U.S., and it has a record of being proactive in addressing government concerns.
For example, it recently introduced a one-hour limit for children under the age of 12 on their games and limits in-game purchases.
The impact of the crackdown aimed at younger gamers should be limited, since minors made up just 0.3% of gaming revenue in the second quarter.
There are risks, though: Its advertising business could be hurt if the economy slows, and as regulation dampens the cutthroat competitiveness that fueled some ad spending.
Tencent is also a stealth venture capitalist, with successful investments in the likes of JD.com (JD) and Meituan, businesses whose valuations are also under pressure.
The risk of further intervention also persists, including losing its preferential tax treatment.
If the tax rate increases to 21% in the second quarter from the 15.5% that Citigroup analyst Alicia Yap has modeled, she estimates a 3% hit to earnings.
Yap has maintained her Buy rating, but cut her 12-month price target 12%, to 689 Hong Kong dollars—45% higher than recent prices—citing near-term pressure on the company’s business because of the fallout from regulation.
Tencent trades at 23 times 2022 earnings, near the trough for the company’s core online entertainment and advertising businesses over the past five years.
That means there’s little value assigned to its fintech and cloud businesses or its investments, says Neuberger Berman Emerging Markets Equity manager Conrad Saldana.
Despite the near-term risks, Saldana expects long-term earnings growth of 20% to 30% as the company makes money off its ecosystem and base of 1.25 billion monthly users.
Yum China
Even nontech companies have been swept up in the selloff.
Shares of investor darling Yum China fell 5% in the past three months.
Yum China has generated free cash flow every year since it was spun off from Yum!
Brands (YUM) in 2016; it is extremely well run and has 7.5% of its market cap in net cash, providing a cushion amid the uncertainty, says Laura Geritz, who runs Rondure Global Advisors.
At 27 times forward earnings, the stock isn’t as cheap as the internet megacaps but also not as much in regulators’ crosshairs.
Analysts, on average, expect earnings per share to grow 27% in fiscal 2021 to $1.95 a share, with revenue growing at about the same rate to $10.2 billion.
Yum’s price drop was amid another round of Covid lockdowns, but the company navigated last year’s lockdowns well, and its scale and experience should help it emerge as a survivor in a market filled with mom-and-pops, Leverenz says, adding that Yum could double its network in seven to eight years.
Plus, China’s redistributive policies aimed at reducing housing, education, and healthcare costs should give lower-income consumers more money to spend on eating out.
The average 12-month stock price target from analysts on FactSet sees Yum China’s stock 19% higher, at HK$570.
Ultimately, the message for investors is one of cautious optimism: China is still a major source of global growth, and home to diligent savers being encouraged to put more of their $75 trillion in household wealth into a stock market filled with companies well positioned for Beijing’s policy makers.
That’s attractive terrain for long-term stockpickers, just one that requires a clear sense of the risks and careful footing.
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