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Chinese delisting, geopolitical, regulatory, and other “investability” issues

Investors have a diverse range of opinions on these issues. Take two well-known investors with several decades of experience: George Soros and Charlie Munger.


In September last year, Soros wrote in the Wall St Journal that “pouring billions of dollars into China now is a tragic mistake”. He specifically highlighted Blackrock’s stance towards China and mentioned that it’s “likely to lose money”.


Conversely, early this year it was reported that the Daily Journal Corp, the publishing and technology company which Charlie Munger chairs, had nearly doubled its stake in Alibaba Group. Charlie Munger also championed Berkshire Hathaway’s highly successful investment in BYD approximately 13 years ago. In reference to China, he also recently stated: "I don't think we should assume that every other nation in the world, no matter what the problems are, should have our type of government" (CNN, November 2021).


Opinions on the sell-side vary too. The Chinese stocks we monitor have, on average, positive z scores for both our consensus recommendation and recommendation revisions factors. However, last month JP Morgan Chase downgraded 28 Chinese internet stocks including Alibaba, calling them “uninvestable” over the next 6 to 12 months due to rising geopolitical and macro risks.


What’s our view? Before answering this question, we will delve into the recent de-listing threats, geopolitical events and regulatory issues which have been driving investor sentiment.

Delisting threats

This topic has attracted a lot of attention recently, particularly among retail investors. Some US retail investors seem to think that if a company delists from the United States, it’s essentially worthless. Clearly this is wrong but given the large retail flows in the United States for many well-known Chinese stocks – including Alibaba, JD.com and NIO – it’s problematic.


There is a special case: Didi (DIDI US). We’ll classify it as the exception that proves the rule. Didi never should have listed on the New York Stock Exchange because of regulatory issues. These issues have resulted in the company halting its planned HK listing and will likely force it to be delisted from New York. This is a big problem as it would result in the company’s shares trading OTC and it would become univestable for many funds, including ours.

Fortunately, a large percentage of the US listed Chinese shares that we monitor have very liquid – and fungible - listings on the Stock Exchange of Hong Kong.

Many of these companies also have very strong balance sheets and don’t need access to US capital markets. For example: Alibaba, JD.com and Baidu all have significant net cash holdings.


There is an argument that stocks listed in the US currently command higher valuations than stocks listed elsewhere, including in Hong Kong. While there is some merit to this argument, it is important to remember that listing premiums can change and fundamentals are, and will always be, the biggest driver of stock valuations. And fundamentals aren’t impacted by where a company is listed.


It’s also pertinent to consider the companies which were forced to delist from the United States due to perceived links to the Chinese military. This includes the 3 large Chinese telecoms stocks – China Mobile, China Unicom and China Telecom. These stocks have very liquid listings in Hong Kong and they satisfy multiple long alpha screens – hence we’re very familiar with their share price performance. They declined following the delisting announcement but have significantly outperformed the Hang Seng Index since then. It is also important to note that US investors have been forced to sell their holdings in these stocks and hence the liquidity threat is more significant than that for the other US listed Chinese stocks (which are not subject to a US investment embargo).


Lastly, on April 1 Bloomberg reported that China is considering giving the US full access to audits of most Chinse firms. If this is the case, the issue will be moot for most Chinese stocks listed in the US.

Geopolitical events

Russia’s recent invasion of Ukraine has sparked some concerns about China’s relationship with Taiwan. Given we don’t proclaim to have any geopolitical insights which would give us an edge over other investors, this is not a topic we will address in detail.

I

mportantly, given our investment style, it’s also not a topic which we need to fully address. We run a diversified multi-factor quant fund and we avoid taking net country bets. Hence, we’re less exposed to geopolitical events than most other funds.

However, an escalation of tensions between China and Taiwan is a tail risk and in keeping with our philosophy of monitoring risk factors which are currently driving investor sentiment rather than risk factors captured by historical models, it is something we have considered. Based on our stock and net sector positioning in China and Taiwan, we believe the fund could withstand the risks posed by such a scenario.


Regulatory issues

Regulatory issues in China rose to prominence following Ant’s failed listing in November 2020. Since then, there have been more adverse developments that have impacted technology, property, gaming, and education stocks. There have also been concerns that, under the guise of “common prosperity”, other sectors could be adversely impacted.


The biggest impact has been on technology stocks which have been forced to adjust their business practices and pay large fines in response to anti-competitive behaviour. These concerns aren’t confined to China. The large US tech behemoths – Amazon, Apple, Alphabet, and Facebook – are currently undergoing antitrust investigations. The big difference is that any laws stemming from these investigations will take a long time to enact as they must satisfy various checks and balances as they gradually work their way through the legislative process. China has a different system of government and can act quickly to address any perceived wrongdoing.


Recently, China’s stance seems to be shifting and commentors are now referring to “peak regulation”. Following a sharp decline in share prices, a senior government official announced in mid-March the government would roll out support for the economy and keep markets stable. This has allayed investor concerns and there is now even talk of the “China Put”.

Our view on investing in China

The fundamental law of active management (as derived by Grinold and Kahn) states that a manager’s risk-adjusted performance is a function of the manager’s skill (or IC) and the number of independent investment opportunities (or breadth).


Historically, our quant factors have generated strong ICs across our Chinese stock universe.

China also offers considerable investment breadth. Although many Chinese A shares are difficult to short, there are numerous H shares with analyst coverage that have low borrow rates. There are also two A share futures contracts that are sufficiently liquid for us to trade.

Our view towards China is also shaped by one of our key investment tenets: invest based on fundamentals; trade based on liquidity flows.


We monitor a diverse range of quant factors to inform our fundamental view on stocks. This includes value, profitability, quality, and sentiment factors.


We monitor liquidity flows via short-term technical indicators. This includes Williams %R factors and factors which combine live share price returns with relative volume indicators.

We have used this investment tenet successfully to exploit numerous market dislocations. This is facilitated by our portfolio construction methodology which enables us to meet our volatility target without using excessive leverage.


The best example is the Great Quant Unwind in August 2007. The fund we were managing generated a positive return that month. To our knowledge, it is the only multi-factor quant fund to achieve this outcome. We were able to do this because we successfully focused on fundamentals – using our proprietary portfolio management system - and were willing and able to take the opposite side of liquidity flows.


A very recent and topical example occurred in March. Early that month, Chinese equities underperformed, but the selling was targeted. The biggest underperformers were stocks most impacted by perceived regulatory and delisting risks. Mid-month that changed. On March 14 and March 15, the Hang Seng Index declined by 5.0% and 5.7% respectively, while other regional markets performed relatively strongly (for example, the Topix Index rose by 0.7% and 0.8% respectively). The selling was indiscriminate with many stocks with strong fundamental factor scores which weren’t under any delisting or regulatory pressures caught up in the downdraft.


We were able to exploit these mispricing opportunities in March and, in so doing, generate alpha.

In summary, we don’t subscribe to the view that China is uninvestable. Chinese stocks are impacted by the same behavioural biases which underpin the predictive power of our quant factors and our investment process. Our ability to focus on fundamental factors during periods of extreme market volatility – which are likely to persist in China as the tug of war between fear and greed continues – should also help us generate alpha.



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