- China’s aging population points to current account deficits ahead and therefore the need for foreign capital inflows. Large-scale delistings and the related fallout would be against China’s best interests.
- Large and strategic Russian ADR companies have granted the PCAOB access without any national security problems. We could be overthinking the China vs. US agenda.
- DiDi’s delisting is likely to be an isolated case and a result of weak network security.
- Both the Chinese and US sides have communicated a willingness to cooperate and reach a middle ground before the Holding Foreign Companies Accountable Act starts to delist Chinese ADRs.
- Alibaba’s cybersecurity capabilities are top in class, which may keep it out of regulators’ crosshairs. Rock-bottom valuations make the stock too cheap to ignore. BUY on the dip caused by delisting fears.
It seems like there’s no end to the bad news for Alibaba, with its share price continuing on its downward trajectory on news of the Chinese government forcing DiDi Global to delist from the New York Stock Exchange. At face value, the news seems to imply that the Chinese regulators have taken the nuclear option and are going to start a wave of delisting of Chinese ADRs, which would potentially implicate Alibaba and send its share price plummeting further. That is certainly the consensus view.
However, in this article, I wish to share my contrarian view that Alibaba will not be delisted, and the share price tumble caused by the fear of delisting has created an opportunity to accumulate shares on the cheap in a company that remains at the forefront of growth in China’s digital landscape.
Let me explain…
China needs foreign capital
China’s population is aging. The country’s population is expected to peak before 2025, and its working-age population has already peaked in 2011. As people age, their savings rate declines because money built up during their working years is used to fund retirement. Bear with me here, but if you recall Economics 101, a country’s current account balance can be expressed as Savings – Investment. If a country is saving less, then its current account balance tends to decline, which is indeed what we have seen with China over the past decade.
Why is this relevant? Well, a country’s current account is part of its Balance of Payments, which is an accounting equation of a nation’s finances and essentially holds that if a country’s current account is in deficit, then that deficit must be offset by inflows of foreign capital. See what I’m getting at?
A Morgan Stanley article published in 2019 highlights how China’s current account surplus has narrowed significantly over the last decade as the country has aged, and they predict that China will require “at least US$210 billion of net foreign capital inflows per year from 2019-2030” to maintain its balance of payments. Yes, COVID-19 has pushed back that trend by a few years, given household savings levels have risen in most economies including China, but those savings will be drawn down once the global economy reopens, and China’s current account will soon be heading for deficit territory again. It’s therefore crucial for the Chinese government to keep the doors open to foreign capital.
Source: Morgan Stanley
In my view, China delisting its ADRs would dent the allure of its capital markets to foreign investors and reduce capital inflows on two fronts, which will not be in its best interest.
Firstly, there’s the impact of Chinese companies no longer being able to raise capital in the US. There are a total of 253 Chinese ADRs listed in the US, amounting to a total market cap of US$1.2 trillion. That’s massive and represents about 6x the amount of annual capital inflows that Morgan Stanley had predicted will be required. Yes, the $1.2 trillion represents money already injected into those Chinese companies and into China’s economy, but it certainly speaks to the size of the potential future capital inflows when those companies raise bonds or equity.
Hold on, you might say, China can have these companies shift their listings to Hong Kong instead, where foreign capital can arrive without the hindrance of US oversight. While that’s true in theory, in practice, things may not be so straightforward, because benchmarks play a big role in influencing asset allocation. The MSCI World Index, probably the most commonly used benchmark for global equities, is overwhelmingly comprised of US equities at a 68.5% weight. Hong Kong equities, on the other hand, are part of the 14.4% “Others” weighting that you see in the pie chart below, which is made up of 18 other countries as well. The contribution of Hong Kong equities toward the global benchmark is therefore very minimal compared to the US. This has implications for active managers with a global mandate who tend not to stick their necks out too much and deviate significantly from the benchmark’s country allocation, as well as passive vehicles, especially index ETFs, who by construction have to hug these benchmarks. The impact on the passive side is particularly pronounced given that passive investments continue to rapidly take market share from active fund managers.
To round up this point, all this means that liquidity and foreign capital is unlikely to shift substantially into Hong Kong, should the ADR delisting and Hong Kong re-listing situation arise. Simply put, nothing beats the US in terms of access to foreign capital.
MSCI World Index by Country Weights:
Active vs. Passive AUM:
Source: Federal Reserve
Secondly, technical factors aside, delisting would send a strong message to the investment community that China has become “un-investable” and decreases the willingness of foreign investors to put money into China. Already, some fund managers like Guggenheim Partners have come out to express that view publicly. Not all may agree, but the uncertainty created by the Chinese government’s shocking moves is sure to weigh on allocations in the future, as fund managers remained scarred by the drags on their performance by China equities.
Could we be too caught up in the US vs. China narrative?
The narrative from the point of view of a cynical investor focused on the rising geopolitical tensions between the two superpowers could be that the US wants leverage when it comes to accessing Chinese data via auditing Chinese technology companies listed in the US, and China in turn wants to protect that data. But from a more practical point of view, could it be that all the US really wants is to ensure proper oversight and auditing over Chinese companies, especially in the wake of accounting fraud scandals like that of Luckin Coffee?
The US Public Company Accounting Oversight Board, a.k.a. the PCAOB, states on their website that “Our principal goal is to achieve a level of cooperation with the Chinese authorities that both (1) respects Chinese and U.S. sovereignty, and (2) enables the SEC and PCAOB to have timely access to the information necessary to conduct investigations or inspections.”. I emphasize “respects Chinese and U.S. sovereignty.” Again, could we be too caught up in the US vs. China narrative to see that this could simply be an issue of protecting US investors by ensuring proper oversight?
In fact, another so-called adversary to the US is Russia, and some of Russia’s largest and companies have ADRs on the US stock exchanges. For example, on the NYSE, you have Mechel Steel, one of Russia’s leading mining and metals companies, you have Mobile TeleSystems, Russia’s largest mobile network operator, and you have Gazprom, Russia’s oil and gas giant. Those all sound like very strategic companies that should be national security assets to me. But we’ve never heard of scandals involving the SEC or PCAOB audits leaking sensitive information on these Russian companies.
Furthermore, earlier in the year, the China Securities Regulatory Commission (CSRC) Vice Chairman held meetings with some investment banks and highlighted that:
- China sees VIE structures as necessary and important
- The regulator intends to continue to allow Chinese companies to list in the US as long as they meet listing requirements
- China is not looking to decouple from global markets
That gives us an inner look into the Chinese administration’s thinking and implies that the Chinese side is also keen to find a middle ground.
In that case, what’s the deal with the DiDi delisting?
DiDi is likely to be an isolated case
In my view, DiDi’s delisting is merely the punishment for its transgressions, namely its inadequate network security, and does not imply that every company with data important to national security should be delisted. The WSJ has reported that China’s regulators suggested DiDi delay its IPO due to cybersecurity concerns, but DiDi went ahead with it anyway. In response, the regulators started a cybersecurity review on DiDi shortly after their IPO, culminating in the current plan for delisting. It has not been revealed exactly what those issues are, but suffice to say, there were lapses in cybersecurity.
Importantly, this may not extend to other companies such as Alibaba which may have better cybersecurity capabilities thanks to its expertise gained from a longer period of operation and knowledge from security-intensive parts of its business like cloud and payments (more on that later).
The case of Ant Financial is another instance that highlights how China is willing to block listings as a punishment more generally. Ant Financial’s listing was blocked because China wanted to crack down on the lax consumer lending practices at the Fintech giant in a bid to enhance financial stability. Again, this was a so-called punishment for company-specific issues but certainly did not represent a blanket ban on Chinese IPOs. In fact in 1H2021 (shortly after Ant Financial’s listing was blocked) there were 34 Chinese ADRs that listed in the US.
What about the Holding Foreign Companies Accountable Act?
To recap, the Holding Foreign Companies Accountable Act was signed into law on 18 Dec 2020. The SEC has said that they must determine that a company has “3 consecutive non-inspection years” before a forced delisting can be made to happen. The first “non-inspection year” would be 2021 and therefore the first companies found to be non-compliant with the SEC requirements could be forced to delist by the first quarter of 2024 at the earliest.
So, the Chinese and US authorities need to work out a deal before 2024. Not all hope is lost.
Chinese regulators have signaled that they want to work with the US to meet SEC requirements. For example, the CSRC said in August this year that it will “create conditions” for co-operation with the US in relation to the auditing of US-listed Chinese companies. The CSRC said again on 5th December that it would respect companies’ choices on where to list, and reports stating that the regulator was asking firms to drop their US listings were “completely misleading”. In fact, collaborating with US and other overseas regulators is enshrined in Chinese law, where Section 117 of the securities law “mandates the CSRC to set up mechanisms for cross-border collaboration with overseas regulators, such as the US SEC and the PCAOB.”
Personally, I can imagine one solution being the onboarding of an independent auditor that both the US and China trust. This independent auditor could be granted access to all the information that the PCAOB requests for, and conduct checks on behalf of the PCAOB, without actually revealing sensitive information. Perhaps China could allow the PCAOB to inspect the independent auditor’s audits at random but only for a tiny proportion of companies per year. This would significantly reduce the likelihood of national security breaches while meeting the needs of both sides.
Alibaba’s cybersecurity capabilities may keep it out of regulator’s delisting crosshairs
To build on my earlier point, Alibaba possesses expertise in cybersecurity thanks to its cloud and payments businesses which demand extremely high levels of security against attackers. In one interview in 2019, Jack Ma said that Alipay, which at the time processed US$50m in payments per day, had yet to lose “one cent” to hackers. He also revealed that at the time, Alibaba was subject to over 300 million hacking attempts per day which the company dealt with effectively and “we don’t even have one problem.” This was chalked up to a large amount of consumer data resulting in better-trained artificial intelligence programs for fraud detection. Unfortunately, Alibaba eventually fell victim to a hacker last year, where 1.1 billion pieces of user data were scraped from Taobao, although no encrypted information (e.g. passwords) was obtained and there was no economic loss. Still, one major hack in the time since its listing is a very good result for Alibaba. Even the Western Internet giants are not completely immune to data leaks. Regulators also have not publicly questioned Alibaba’s network security capabilities, and I therefore believe that Alibaba will not go the way of DiDi. We must recognize that Alibaba is a better-managed company and differentiate between the two.
Summary, and what to do with the shares
In summary, although we have seen a deluge of newsflow around Chinese ADRs that, at face value, seems to imply a wave of delistings lies ahead, looking deeper into the motivations of both the US and China, as well as what regulators have said, I do not believe that the worst-case scenario of delisting will play out for Alibaba, especially given its robust cybersecurity capabilities.
Does the current selloff due to delisting fears then warrant a re-look at Alibaba? I do think so. Even though I highlighted in my previous article that competitive headwinds and a macro slowdown portend continued fundamental weakness in the near-term, after a precipitous 33.5% drop in its share price since mid-November, the stock is now looking too cheap to ignore. Alibaba’s forward P/E ratio is at an all-time low of about 14x. Even factoring in a period of slower growth ahead due to a weak macro backdrop in China, and stiffer competition from the likes of JD, Alibaba is still expected to grow both its topline and EBITDA at about 20% over the next two years. That translates to a PEG ratio of about 0.7x (using EBITDA growth as the denominator here since it tends to exclude more one-off items) which is very cheap for a market leader in multiple growth sectors in China (e-commerce, cloud). I’m therefore turning bullish on Alibaba shares and recommending to buy the dip.
Source: Bloomberg, author’s charts
Consensus estimates for Alibaba:
Author: Invest To Retire, Seeking Alpha