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Tech stocks & regulatory risks in China

Updated: Feb 14, 2023

Following Didi’s IPO in late June, regulatory risks in China have attracted a lot of attention. Almost immediately after the IPO, the Cyberspace Administration of China announced it had launched an investigation into the company. The regulator subsequently announced Didi’s mobile app would have to be removed from app stores in China on the basis the company was illegally collecting and using personal data.

Other reasons have also been put forward for recent regulatory crackdowns. Most have focused on antitrust concerns. Numerous Chinese internet companies have been forced to pay large fines and change their business practices following allegations of anti-competitive behaviour. Ant Group’s IPO, which would have been the biggest ever, was also halted by regulators days before it was due to list in November 2020 due to financial risks and the fact it was acting as a financial intermediary without been regulated like one.

[Update 28 July 2021: Recently, the regulatory risks have broadened. The government has severely curtailed the activities of education businesses offering after school tutoring. Food delivery businesses have also been targeted and now face much higher labour costs. The government is also getting more serious about property speculation and dealing with housing affordability. Issues such as the rights of "gig workers" and housing affordability have recently been the subject of debate outside of China and increased regulatory oversight in other countries is a possibility, but any regulatory changes are likely to be more gradual.]

The one thing all these regulatory crackdowns have in common is their share price impact. In all cases, the market’s reaction has been swift and severe. And it’s not just the targeted companies that have been affected. The Economist reported that “the day after the Didi ban the four biggest tech groups with listings in Hong Kong—Tencent, Alibaba, Meituan and Kuaishou—lost a collective $60bn in market capitalisation”.

Another risk is also emerging. Calls to ban Chinese companies from US exchanges have grown louder. Marco Rubio, a Republican senator from Florida who called on Didi’s IPO to be blocked, said it was "reckless and irresponsible" to allow Didi to list on the New York Stock Exchange. The Chinese government has also indicated it is not happy with a recent law passed by Congress that provides for more detailed accounting and auditing oversight of Chinese companies. The Chinese government is preparing new laws which will restrict foreign scrutiny of Chinese companies with offshore listings. This is a big issue given there are currently almost 250 Chinese companies that are listed in the United States.

So, what does all of this mean for our non-systematic quant investment process?

The first point to make is it highlights the importance of constructing portfolios manually while considering all risks currently impacting market sentiment. Risk models based on historical correlations are not properly calibrated for more hawkish regulatory oversight in China. This precludes the use of an optimiser to construct the Fund’s Chinese portfolio.

One approach is to aggressively reduce gross exposure to Chinese technology stocks. Reportedly, Cathie Wood did this for the Ark funds. According to Bloomberg, “China’s weighting in Wood’s flagship Ark Innovation ETF plunged to less than 1% from 8% as recently as February” (July 14, 2021). She justified her actions on the basis that Chinese tech stocks are deserving of a “valuation reset”.

In our case, our net exposure to Chinese technology stocks has always been very small. The question then becomes: should we reduce gross exposure?

There are a couple of key issues to consider when answering this question. One is antitrust concerns are a global issue as governments, businesses and consumers increasingly express their unease over anti-competitive behaviour. Due to the nature of China’s political system, Chinese regulators tend to act quickly and unexpectedly. The approach in the West is to debate the issues before acting. The appointment of Linda Kahn, an advocate for stricter antitrust laws, as chair of the Federal Trade Commission will almost certainly ensure these issues are debated more openly. Stricter antitrust laws are a likely outcome. There are global forces at play and a harsher regulatory environment won't necessarily be restricted to China.

We also have the ability, via our non-systematic overlay, to analyse regulatory risks vis-à-vis each company’s valuation and growth profile. In some cases, regulatory risks seem to be more than fully priced given valuation and growth metrics. There are currently several Chinese tech stocks that come through our long alpha screens. Conversely, there are still Chinese tech stocks subject to regulatory risk that are being identified by our short alpha screens.

Portfolio breadth also helps mitigate stock specific regulatory risks. We have numerous Chinese tech stocks in the portfolio, none of which have an absolute position size which is greater than 1% of AUM.

Another issue is that pressure to delist Chinese tech companies is likely to persist. The “tough on China” stance initiated by Donald Trump has broad bi-partisan support in Congress. Anti-China sentiment is growing and taking a tough stand against China is a vote winner. Similarly, Chinese patriotism is becoming more pronounced and pushing back against “Western imperialism” enjoys widespread support amongst the Chinese population. The pressure to delist Chinese tech stocks listed in the United States, therefore, could come from both the Americans and Chinese. It is a material risk that could particularly impact tech stocks which are solely listed in the United States (ie stocks that don’t have a dual listing).

It is also interesting to note that Chinese stocks which are solely listed in the United States are considerably more expensive that Chinese stocks listed in Hong Kong. Using the Median One Year Forward Earnings Yield as a simple measure of value, the yield for the US stocks is 3.4% vs 9.3% for the HK stocks (as at 15 July 2021). This partly reflects different sector compositions with a relatively large number of Information Technology and Biotechnology stocks listed in the United States. Nevertheless, if we restrict the stock universe to these sectors, the difference is still substantial (-0.8% vs +3.1%).

[Update 28 July 2021: Since I wrote this research note, Chinese stocks listed in the United States have declined sharply, absolutely and relative to Chinese stocks listed in Hong Kong. However, there is still a large valuation difference.]

Given all of this, our approach is to:

  • Keep net exposure to Chinese tech stocks very close to 0%

  • Maintain our gross exposure and portfolio breadth

  • Review the alpha profile and regulatory risk for each key holding based on its business operations and market share, and position the portfolio accordingly

  • Maintain a slight net long exposure to Chinese tech stocks listed in Hong Kong and a slight net short exposure to Chinese tech stocks listed in the United States.

This illustrates the use of the non-systematic overlay from a micro perspective (analysing each stock’s alpha profile and regulatory risks) and macro perspective (maintaining gross exposure to Chinese tech stocks and having a slight net bias based on country of listing). Historically, both components of the overlay have been a strong source of alpha and risk mitigation.

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