China Regulatory Shock – What’s Next For Internet Stocks

Summary

• The massive and synchronized sell-off of Chinese equities was akin to a Golden Slam for the critics. It was a glorious moment for the horde of “I told you so!”
• I explain why I kept rooting for U.S.-listed Chinese ADRs in the face of myriad adversities and discuss if Chinese internet stocks are now uninvestable.
• NetEase playing second fiddle to Tencent, whether in games or social media, is a blessing in disguise. Furthermore, NTES valuation is not high, to begin with.
• Alibaba’s upcoming results could disappoint as management avoids rosy profitability outlook and potentially warns on dimming growth prospects as tech giants crowd into the remaining state-favored sectors.

Shareholders of Chinese stocks endured an excruciating week of a severe emotional storm with the share prices undergoing a rollercoaster ride. A potent mix of anxiety, fear, anger, and regret overwhelmed the mind amid a deluge of news, speculations, and commentaries as market participants attempted to make sense of Beijing’s thinking.

Naysayers of Chinese equities scored a magnificent Olympic-sized victory in November when the share price of Alibaba Group Holding (BABA) came crashing down as regulators put an abrupt halt to the initial public offering (IPO) of its financial technology unit, Ant Group. That episode now pales in comparison to what happened over the previous weekend.

Chinese authorities confirmed an official ban on for-profit after-school tutoring firms on Sunday, sending the already decimated education stocks plunging further as the week began. With the crackdown on the education sector more cataclysmic than the worst-case scenario, investors feared the “China discount” was woefully insufficient for the elevated regulatory risks facing the whole spectrum of Chinese companies.

The resultant massive and synchronized sell-off of Chinese equities, especially the U.S.-listed ones, was akin to, in tennis speak, a Golden Slam for the critics. It was a glorious moment for the horde of “I told you so.” The representative ETFs of Chinese companies (CQQQ)(FXI)(ASHR), unsurprisingly, underperformed their U.S. counterparts (QQQ)(DIA)(SPY) by a wide margin for the week.

The Invesco China Technology ETF suffered the worst hit among the broad-based ETFs on Tuesday. Seven of its top ten holdings are internet platform-based businesses catering to consumers like Tencent Holdings, a key focus area of the regulators lately, and/or counters popular with American investors like GDS Holdings Ltd (GDS).

The fall of innocuous liquor giant epitomizes the breadth and depth of the bearish mood

I noted in the last update that Mainland Chinese were reducing their exposure to such stocks amid the uncertainties, based on trading data from the Southbound Stock Connect program. It doesn’t take much imagination to think their U.S. counterparts would be even more jittery and bailout.

For those who are still not convinced of the bearish sentiment, have a look at the share price chart of Kweichow Moutai Co Ltd. The best-known distiller of the fiery, throat-tingling Chinese spirit baijiu has long been a market-darling. The world’s most valuable liquor company is also the largest Mainland China-listed firm by market capitalization.

The X-trackers Harvest CSI 300 China A-Shares ETF has Kweichow Moutai as its top holding at 5.5 percent of the portfolio weight. The next largest holding is some distance away at 3.0 percent. Kweichow Moutai is not an essential item of the Chinese consumer. It doesn’t engage in monopolistic practices and its possession of customer data is a far cry from the internet companies. Listed only on the Shanghai Stock Exchange in Mainland China, it is neither subject to geopolitical tensions or delisting risk from the U.S.

In other words, Kweichow Moutai is not facing any of the pressures the other Chinese companies are experiencing. In the past, there was a popular saying “nobody ever got fired for buying IBM” (IBM). In China, Kweichow Moutai is the IBM. Yet, it is down 35.5 percent from the February peak and is trading way below its 200-day moving average.

Thus, what more can we expect of the beleaguered Chinese internet stocks, many of them listed in the U.S.? The sector representative ETF, the KraneShares CSI China Internet ETF (KWEB) tanked a whopping 8.6 percent for the week even after a strong rebound from Tuesday, when most of its holdings dived.

Among the largest holdings of the KWEB ETF, the share prices of lifestyle services giant Meituan (MEIT)(OTCPK:MPNGF)(OTCPK:MPNGY) declined the most, sinking 19.4 percent for the week. The steep fall came as the Chinese authorities made good on their promise to address the low compensation of the gig workers engaged by Meituan by stipulating the company pays them the local minimum wage as well as to assist with their medical insurance and pensions.

I detailed in a 2 May 2021 article titled The Great Reset For Chinese Internet Giants the dreadful experience of a Beijing labor official working undercover as a Meituan courier doing a 12-hour shift. I noted then that the potential government actions would be rather inconsequential for Alibaba as its food delivery business is small compared to the overall group revenue:

“To be sure, Alibaba’s food delivery platform Ele.me has operated similarly in this competitive business. Thus, any rectification ordered by the authorities may also apply to Ele.me. Higher compensation for each order, coupled with reduced penalties for late deliveries, is to be expected, crimping the margins for the delivery companies. However, it’s important to note that food delivery is a small portion of Alibaba Group’s revenue, unlike Meituan.”

On the other end of the spectrum, NetEase, Inc. (NTES)(OTCPK:NETTF) appeared relatively unscathed from the bloodbath, closing down only 1.2 percent lower for the week. On Tuesday, however, it was a different story as shareholders sold off NTES stock ostensibly due to the collateral damage from the tumbling of Youdao, Inc. (DAO), its edtech unit.

As Youdao staged a strong rebound together with several other Chinese education stocks, NetEase bounced along higher as well. I wondered last week if investors were ignoring a substantial part of Youdao’s businesses that didn’t seem to be affected by the new policy:

“The indiscriminate selling was despite Youdao having a diversified business offering which includes the sale of hardware-based learning products such as dictionary pens and pocket translators, as well as interactive learning apps and online courses for adults. Sales of dictionary pens grew a blistering 198 percent year-on-year in the first quarter of 2021.”

Perhaps shareholders also came to realize that NetEase playing second fiddle to Tencent, whether in games or social media, is a blessing in disguise. It might not be as impacted by the stricter antitrust regulations and its comparatively much smaller trove of user data could put it in diminished scrutiny from the authorities.

Furthermore, NTES valuation is not high, to begin with. Even if its growth is curtailed and its profitability is crimped, it would be trading in the sub 5x forward price-to-sales ratio and low 20x forward price-to-earnings ratio in the next few years.

Source: Seeking Alpha Premium

As explained in a past issue of the Chinese Internet Weekly, I found the KWEB ETF holding the most representative stocks in the sector. As such, an overview of the week’s share price movements of the top ten holdings of KWEB (as of Friday) as compared with the ETF itself is provided as follows for convenient reference especially for the stocks mentioned in this article.

Data by YCharts

Why had I kept rooting for U.S.-listed Chinese ADRs in the face of myriad adversities and uncertainties?

A prototype of sorts for this series of Chinese Internet Weekly (CIW) was published on November 12, 2018. The inaugural CIW followed two weeks later, while market players were still hung-up with the U.S.-China trade war, and days ahead of a highly anticipated meeting between the former US President Donald Trump and Chinese President Xi Jinping at the G20 intergovernmental forum.

The motivation for starting the column was sparked by a desire to counter the barrage of the negative narrative surrounding the Chinese equities and by extension, China’s economy. As I had near-monthly business trips to China and built a network of contacts on the ground, I reckoned I could add a first-person perspective to the development updates of the companies CIW would cover. It wasn’t meant to be an altruistic move as I was vested in several Chinese stocks and dutifully declared in every article.

Through 2019, I argued that the business fundamentals of the Chinese internet giants would hardly be hampered by the trade tensions, Tencent would overcome the heightened regulatory scrutiny on games, and defended the resilience of the Chinese economy amid the prevailing macro challenges. It is inconceivable that the CQQQ ETF has still managed to be 62 percent higher from the publication of the latter article, despite the recent collapse in prices. Even more incredulous is the fact that the S&P 500 climbed only 51 percent in the same period.

Source: Screenshot from Seeking Alpha on 30 July 2021

I wasn’t a starry-eyed investor-writer on Chinese internet stocks. Over the course of 2019, I dutifully covered JD.com’s (JD) fraud accusation, setbacks at NetEase, and the emergence of ByteDance (BDNCE) as a formidable tech player. I also did not shy away from using less than rosy titles reflecting the prevailing circumstances e.g. Chinese Tech’s Triple Whammy, And Baidu’s Limits For iQIYI.

Yet, those weren’t sufficient to shield me from being bombarded with harsh criticisms that exacerbated in 2020 as I continued to address the Unjustified Revulsion Towards Investing In Chinese Companies. Contrary to popular belief, I am not an unconditional bull on Chinese stocks. I had issued several “Very Bearish” calls last year though one turned out to be unwarranted.

Source: Screenshot from Seeking Alpha on 30 July 2021

The rapid plummeting of my entire Chinese portfolio was hard to swallow and digest, leaving my stomach feeling squirmy. However, what’s more disheartening was the vacillating sense of defeatism as an investment writer, for reasons the previous article Chinese Internet Stocks: Resistance Is Futile has intimated.

Where did the China bulls, including yours truly, go wrong? It wasn’t the manifestation of the oft-mentioned risk in the form of Variable Interest Entities (VIEs), a result of the stocks failing to meet the conditions under the Holding Foreign Companies Accountable Act (HFCAA), or a consequence of devastating systemic fraud discovered across-the-board.

I argued previously why the VIE risk is misrepresented and why the motivation for the HFCAA could diminish with the sacking of William Duhnke III, the previous chairman of the U.S. Public Company Accounting Oversight Board (PCAOB). I also assessed a number of reports by short-sellers and disagreed with the findings for stocks I covered, such as iQIYI (IQ).

Negative externalities such as the trade war and the COVID-19 pandemic did not crush the Chinese internet stocks as feared. The conclusion of the antitrust investigation into Alibaba Group also proved the critics wrong, with the fine quantum much smaller than analysts’ expectations while the requested rectifications were reasonable.

It was this conviction that the risks touted by the bear camp were either unsubstantiated or trivial that I felt substantial upside could be derived by investing in U.S.-listed Chinese ADRs. Furthermore, there was this notion that while Beijing would hobble the companies to restrain the unbridled growth in the private sector, it wouldn’t cut off its nose to spite its face. That is to say, drastic actions weren’t anticipated, and not at the alacrity we witnessed over the last fortnight.

China Speed Cuts Both Ways

Less than two weeks ago, the world’s fastest train made its debut in Qingdao, China. A maglev bullet train that can reach speeds of 600 kilometers per hour (373 miles per hour) greeted the media and observers invited to the event. It is such practical infrastructure investments made all over the country that e-commerce companies have benefited from.

China’s rapid economic growth, in large part, contributed by the fast pace of technology advancement and adoption, was a key supportive factor for Chinese equities. Unfortunately, the bulls now learned the hard way that the China speed can be detrimental to our investments.

It wasn’t that the Communist Party of China (CPC) did anything unfathomable. Its tackling of social ills and deepening inequality resulting from the pursuit of profit has parallels with the U.S., as illustrated by three pertinent examples cited in a Bloomberg article:

• Florida’s embrace of a $15 minimum wage isn’t unlike Beijing’s demands toward Meituan’s delivery staff.
• President Joe Biden’s recent executive order to promote competition shares some of the same goals as China’s actions.
• The steps essentially gutting the for-profit tutoring sector come against a backdrop of rapidly rising education expenses. Democratic lawmakers in Washington are trying to address the same issue via free community college tuition.

The difference is that the world is now well cognizant China can implement the changes across multiple cities, if not the entire populous country, and it can do so swiftly. Furthermore, the extent of how far the Chinese government is willing to go to achieve its aims e.g. the conversion of an entire industry – after-school tutoring – to non-profit organizations “has shocked even some of the most seasoned China watchers,” as a Bloomberg commentary noted.

There’s also a renewed appreciation that what President Xi Jinping had expressed in the past would come to fruition eventually. Momentary inaction is not an indication of approval or tolerance of the transgressions. As the stock wreck unfolded last week, a snippet of a 2018 speech by the Chinese leader in which he stated the education industry “should not become profit-driven” and that “we should regulate these training organizations pursuant to the law and make them focus on well-rounded development of students” made its rounds.

President Xi spent the early years of his reign focused on combating the endemic corruption problem in China. He then shifted his attention to the elimination of poverty and declared a “complete victory” on the campaign at a ceremony in Beijing on 25 February 2021. It seems, therefore, he is now embarking on his other priorities, including social ills stemming from “disorderly capital expansion.”

In hindsight, warnings from the General Secretary of the CPC should have been taken more seriously. He had painted the domestic market for K-12 off-campus education services as a “social problem” in March and criticized the industry’s “disorderly development” at a meeting in May. Hence, as the clampdown on the tutoring industry per his directive three years ago has demonstrated, investors’ jitters over what’s next to expect are warranted.

Healthcare and property sectors are coming into the crosshairs

I mentioned last week the property sector was another casualty of the regulatory clampdown:

“Since the motivation for the tutoring industry crackdown was to lower the cost of child-rearing, it wasn’t a coincidence that the property-related counters suffered a big drop on Friday as well. Homeownership has long been an impediment to household formation in many cities in China.”

Turns out, healthcare is a natural extension of this concept. As China’s population becomes grayer, medical costs are expected to escalate and take a great portion of household income. Telehealth platforms Alibaba Health Information Technology Ltd (OTCPK:ALBBY)(OTCPK:ALBHF), JD Health International Inc (OTCPK:JDHIF)(OTCPK:JDHIY), Ping An Healthcare and Technology Co Ltd (OTCPK:PANHF)(OTCPK:PIAHY) saw their share prices tumbling in the last two weeks.

WuXi Biologics (Cayman) Inc (OTCPK:WXXWY)(OTCPK:WXIBF), a provider of open-access, integrated technology platforms for biologics drug development, Zai Lab Ltd (ZLAB), an innovative, research-based, commercial-stage biopharmaceutical company based in China and the U.S., as well as BeiGene Ltd (BGNE)(OTCPK:BEIGF), a biotechnology company that specializes in the development of drugs for cancer treatment, also suffered varying levels of declines in their stocks.

With mounting challenges, are Chinese internet stocks uninvestable?

I ended the previous article with:

“The beleaguered U.S.-listed Chinese equities could one day prove to be multi-baggers as the scrutiny showed the businesses are far from fraudulent and are having substantial clout on the economy. For now, though, they are highly speculative and probably more suitable for buying on dips and selling on rebounds as well as options trading.”

Naysayers are having a field day because the Chinese stocks have headed south spectacularly. Many readers reached out to me to confirm if I truly meant what I said in the above statement, particularly the phrase “highly speculative”. Well, although most critics did not get the crux of the swoon correct, what matters is that our portfolio is deep in the red and it seems the circumstances have indeed swung against the optimists.

Chinese equities tanked not because Beijing declared the VIEs illegal or any of the ADRs failed to comply with the HFCAA. It wasn’t because of a drag from the trade war or the pandemic. A speculated vendetta between Xi Jinping’s factional rivals and Party interest groups touted as the cause of the crackdowns also wasn’t convincing because of the broad-based impact on the after-school tutoring industry that also embroiled a plethora of small-and-medium enterprises (SMEs).

Although the near-complete destruction of the public Chinese education stocks whether listed in the U.S. or Mainland China/Hong Kong hogged the media limelight, SMEs are also reeling from the new regulations. A businessman in the Shenzhen-based education training sector interviewed by SCMP lamented:

“As a private SME, the pressure is huge. It is the first time this has been felt so strongly. Everyone’s investment and efforts for so many years will be nothing overnight. We once believed the education training industry would keep booming as one of China’s most stable consumer demands.”

Similarly, talks that actions were taken against Alibaba Group, DiDi Global (DIDI), and Full Truck Alliance (YMM) because General Secretary Xi didn’t want their common foreign shareholder, Masayoshi Son of SoftBank Group (OTCPK:SFTBY)(OTCPK:SFTBF), to prosper also don’t hold water. This is because Tencent, which counts Naspers Limited (OTCPK:NPSNY)(OTCPK:NAPRF)/Prosus N.V. (OTCPK:PROSY)(OTCPK:PROSF) as a major shareholder, has also been under fire.

Its music streaming unit, Tencent Music Entertainment (TME) was recently ordered to give up its exclusive music licensing rights. Its ubiquitous messaging app WeChat had to temporarily suspend the registration of new users in mainland China last week.

Just as you screamed “give me a break,” the Ministry of Industry and Information Technology (MIIT) announced on Monday that it had launched a six-month campaign to rectify serious problems with internet apps violating consumer rights, cybersecurity, and “disturbing market order.”

If you are thinking, wait a minute, I have not heard of MIIT all this while, you are correct. Investors are familiar with the State Administration for Market Regulation (SAMR), the antitrust and consumer protection body. Thanks to the DiDi debacle, we have become aware of the Cyberspace Administration of China (CAC) which polices content, privacy, and cybersecurity.

Going back a few months, readers may also recall the involvement of the People’s Bank of China (PBoC), the nation’s central bank that was instrumental in setting new rules on lending, payments, and the “rectification” of Ant Group. Thus, the reassurance offered by China’s securities regulator on Wednesday that Beijing does not intend to “hurt companies in other industries” in its attempt to ease market fears is probably short-lived.

With the dozens of government agencies regulating China’s tech industry believing that they now have the Chinese president’s back and officials wary of being accused by the leaders of lackadaisicalness, investors should brace for more negative surprises on the horizon.

Since tech firms in China have grown so pervasive that they are in every aspect of life and business in the country, the industry is inevitably implicated in most of the policy changes made by the government. Beijing has demonstrated its strong determination to fix long-standing societal issues even at the expense of the economy.

The setting of the least ambitious economic growth goal in decades earlier this year was perhaps a signal that the CPC was prepared for a possible drag on the economy with the reforms. Investors, thus, probably shouldn’t stand in the way, lest we get whipsawed.

What should investors watch for?

Despite the risks, there will be investors still keen on Chinese internet stocks. The low valuation and growth prospects as the Chinese economy expands continue to be the attraction. The Financial Times reported the chief executive of DWS, one of Europe’s largest investors, shrugging off the regulatory “noise” and arguing that China “will deliver vast profits” for those who take a long-term view.

A fund manager whose firm was named the best Asian billion-dollar hedge fund in Eurekahedge’s 2020 awards confessed to misjudging the severity of Beijing’s crackdowns in the education sector. Nonetheless, he concurs on the positive outlook and remains adamant that the fundamentals are “right in the long term.”

The million-dollar question is, just how many years are they talking about when they say “long-term”? Are you prepared to hold onto your investments for a decade or longer? What are the opportunity costs?

Alibaba Group is scheduled to report its fiscal first-quarter 2022 results for the three-month period ending June 2021 on Tuesday. Analysts have duly revised their EPS estimates downwards in response to the tough regulatory environment and the management’s declaration to invest incremental profits back into the business for the current fiscal year.

However, I’m afraid Wall Street is too optimistic that the whole episode would blow away by next year. The 25.6 percent growth in the consensus EPS estimate for the next fiscal year means an additional $6.8 billion in net income for Alibaba Group. That figure is likely too ostentatious to announce without incurring a reaction from the authorities striving to placate the population coping with inflation.

Source: Seeking Alpha Premium

Therefore, I anticipate that Alibaba executives would take pains to reiterate their investment of additional profitability and express the undertaking of this course of action over a longer period. There could also be headwinds from impairments of the investments made in the targeted industries like off-campus tutoring. At the same time, its growth prospects could be curtailed as tech giants and venture capitalists crowd into the remaining seemingly state-favored sectors like electric vehicles (EVs) and semiconductors.

Shareholders wouldn’t like a flat profit growth. Nevertheless, when the e-commerce and cloud giant can derive a greater portion of its profits outside of China as I argued in June, the management would be more comfortable to announce a higher increase in EPS.

Specifically for the education startups like Tencent-backed Yuanfudao and Alibaba-backed Zuoyebang, I believe they can endeavor into overseas markets with their technologies. Yuanfudao claims its algorithms identify common student errors, enabling it to run an “ingenious math problem-solving app” that parents use to check their kids’ homework. Since the mathematics subject is rather universal, I suppose the company can offer the service globally. Similarly, Zuoyebang could export its educational products and services to overseas students or set up shop in other countries.

Shareholders must have the patience and the stomach to withstand the volatility. Reliance on the Chinese state media to ameliorate market swoons could work like it happened last week. However, it doesn’t seem like a sound game plan for the long term.

Shareholders also must be diligent in following up with and distilling policy changes as advised by a Shanghai-based venture capitalist. Those willing to put in the additional efforts and possess extraordinary investor traits could enjoy the alpha.

Author: ALT Perspective, Seeking Alpha