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Don’t Give Up on Investing in China

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What You Need to Know

  • The unpredictable regulatory environment adds significant risk, but the country remains an important and still-viable market.
  • Many of the issues addressed by Chinese regulators mirror the concerns of Western governments.
  • Long-term winners in China will be attractive to consumers and provide infrastructure to support economic growth in the eyes of the government.

The Chinese government has moved at a fast pace to realign the relationship between private companies and the state, a policy reset that prioritizes national goals over the interests of foreign investors. For many investors, the crackdown on Chinese education companies is a game-changer, effectively transforming the industry from for-profit to not-for-profit status. Chinese education stocks collapsed after the crackdown, leading to a widespread sell-off of Chinese stocks.

Although the unpredictable regulatory environment adds significant risk to investing in China, it is premature to write off the Chinese stock market. China remains an important and still-viable market for investors, given the importance of China’s economy to the world and the abundant opportunities among the large number of Chinese stocks.

Recent events, however, underscore the importance of investing carefully in a market in which analyzing government policy is as important an investment consideration as examining financial statements and evaluating company management. Investors should be cautious about near-term risks but appreciate the long-term opportunities in China.

Regulatory Intervention

Chinese regulators can move more decisively than their counterparts elsewhere in the world, with positive and negative implications associated with the ability to act with few constraints. Chinese regulators say the reforms are intended to curb negative social impact and promote shared prosperity rather than take over the private sector or close equity markets.

Foreign investors are understandably skeptical about after-the-fact explanations for the series of regulatory actions. But despite the opaque and seemingly arbitrary steps taken by the Chinese government, many of the issues addressed by these regulators mirror concerns that Western governments have about systemic risk in the financial sector, anti-monopoly enforcement, data security, income inequality, and protection of small and medium-size enterprises. 

For example, the eleventh-hour cancellation of the Ant Financial IPO was in part an effort to reduce systemic risk. Ant was far more leveraged than the typical Chinese bank while retaining little of the risk associated with loans originated on their platform. The tightening of regulatory controls over Ant resembled the steps taken by U.S. regulators in the aftermath of the global financial crisis.

E-commerce platforms such as Alibaba and JD.com have been targeted for exclusivity arrangements that constrain competition; ending exclusivity practices should increase competition and help smaller businesses. As is the case in the U.S., pay and working conditions for gig workers is a hot topic. With millions of Chinese gig workers delivering food, goods and people for companies such as DiDi and Meituan, worker welfare is an important area for regulatory scrutiny. 

The harsh crackdown on education companies is a byproduct of concerns about the financial burden on parents, the implications of income inequality, and the categorization of education as a “public good.” The for-profit education sector, which includes three companies listed in the U.S., inflated costs of raising children, contributing to falling birth rates — a key focus of Beijing. Although it had been clear that tighter regulation was on the horizon, the new rules are harsher than expected.

An important lesson from the move against education firms is that China’s government is not afraid to implement regulations that constrain the profitability of private companies. That lesson bears implications for all Chinese internet firms. 

The Role of the Private Sector

Capital committed by foreign investors has helped make China a wealthy country. Growth in the private sector in China has raised the living standards of Chinese citizens and moved many out of poverty. The Chinese economy depends on the private sector to provide jobs, growth and innovation — all critical elements of national goals to provide social stability, self-sufficiency and high-quality growth. The importance of the private sector to China’s growth and continuing need for foreign capital represents constraints that make worst-case scenarios less likely.

China’s policy priorities and concerns are well known; regulations including those for fintech companies such as Ant, e-commerce platform companies such as Alibaba and Didi, and for-profit education companies were targeted and tied to known objectives. Unfortunately, specific regulatory actions to address policy priorities are likely to remain unpredictable.

Under Chinese leader Xi Jinping, markets are likely to serve the Communist Party and the real economy first and investors last. Consequently, investors should price in a more active and unpredictable regulatory position from authorities, particularly in segments of the economy that are considered important to China’s national security. Companies that are central to China’s national objectives are likely to benefit from state intervention. Those that go against national objectives may see more intrusive government intervention. 

Conclusion

At the sector level, investors should evaluate whether the sector is on the right or wrong side of the government’s priorities. Segments that further the objectives of social stability, self-sufficiency and productivity are likely to see regulatory tailwinds; companies perceived to detract from these objectives may be subject to regulatory sanctions or restrictions.

Although companies such as Didi and Meituan have been under scrutiny for their pay and treatment of gig workers, the government recognizes the importance of the jobs both companies provide for Chinese workers. Promoting “common prosperity” is a major objective for the government, implying actions to reduce the cost of education, improve affordability and access to health care, and reduce the cost of housing.

The government has already acted to restrain drug prices but is encouraging innovation to help support the country’s aging demographics. Speculation in the housing market is a longtime target of Xi. According to him, “houses are for living, not speculation,” so investors should be prepared for further steps to curb house price appreciation and create a viable rental market for houses and apartments.

Company-level analysis is also important. Investors should assess whether companies can comply with new rules, understand the cost to comply, and the impact of regulation on the market opportunity. An important dimension of fundamental analysis of Chinese companies will be assessing the societal implications of company activities and the risks associated with going against the grain of Chinese society.

The Chinese government will continue to need technology, capital and support from private companies, large platforms and foreign investors. The long-term winners in China will be those companies that can offer a new and improved way of doing things that is both attractive to consumers and provides infrastructure to support sustainable economic growth in the eyes of the Chinese government. 


Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.

Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.

Daniel is a graduate of Brandeis University and earned his MBA in finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the board of trustees of the Green Century Funds.