By Juliana Hansveden, Portfolio Manager of Nordea’s Emerging Stars Equity Strategy
China’s recent policy tightening against the tutoring industry and internet platforms has affected investors’ confidence about China, despite Beijing remains committed to opening up its capital markets. These latest changes in the current regulatory environment in China should help the government to make its way through companies/sectors that they are concerned are becoming too dominant or are negatively affecting society/livelihoods.
First, China's massive new regulatory actions concerning the internet sector have already rattled investors and saw Beijing launch a data-related cybersecurity investigation into ride-hailing giant Didi Global Inc just two days after it raised $4.4 billion in a New York initial public offering.
In this context, we have not made any significant changes to our Chinese big tech holdings in the portfolio. We remain overweight Alibaba, Tencent and Meituan. All three companies have corrected since Chinese regulators started investigating Didi after its IPO as sentiment has deteriorated among market participants. The Chinese regulators seem to be focusing on Chinese companies that possess large amounts of data and are listed in the US and are majority owned by foreigners. However, we are not shareholders of Didi and we only have exposure to one Chinese ADR – Kingsoft Cloud – which is only a 1% holding in Nordea’s Emerging Stars Equity Strategy.
The direct impact from the Didi regulatory investigation is limited to Tencent which owns a small share of the company post IPO, but the magnitude is negligible. Alibaba, Tencent and Meituan are all down significantly from their peaks and we believe the regulatory risks are more than priced in. All three companies are already listed in HK and they have already been scrutinised by Chinese regulators recently.
When it comes to Meituan, which is one of our holdings, there is also regulatory scrutiny but for different reasons. Meituan employs a large number of delivery drivers, creating lots of jobs, but the government wants to make sure they are adequately protected. Therefore new policies include Meituan paying for injury insurance and social security, among other things. We expected increased labour protection to come through at some point when we bought Meituan, but we thought it was outweighed by the attractiveness of the business, and we didn’t think it would impact the value of the business too much. And, according to our estimates, the direct financial impact is likely to be relatively small and we believe a part of the increased cost can be passed on to customers. We believe Meituan’s recent 30% fall more than prices all of this, even if there is further scrutiny on their market share. When it comes to other tech/internet companies like Alibaba, Tencent and others that have sold off it is more sentiment driven. These companies have already been investigated by the regulator and we believe they are unlikely to be significantly impacted from here.
Going forward, we expect Chinese ADRs gradually to delist from US stock exchanges and relist in HK. We are cautious about investing further into Chinese ADRs as there is increased scrutiny from both US and Chinese regulators. Going forward we would expect Chinese companies to list elsewhere, primarily in HK, if they want to attract foreign investors.
The education sector has been under regulatory scrutiny for a long time and this is one of the reasons we have chosen not to invest in it. China is barring tutoring for profit in core school subjects to ease financial pressures on families that have contributed to low birth rates, news that sent shockwaves through its vast private education sector and share prices plunging. Earlier, the government limited the hours permitted for K12 (primary school) after-school tutoring, stipulated a minimum floor space per child, and demanded that the tutoring was to take place on lower floors for safety. The government is concerned that after-school tutoring could have a negative effect on children’s health as they are spending too much time sitting still after school when they should be out playing, on top of having too much homework, which is understandably quite troubling for them. In addition to that, more than 75% of students aged from 6 to 18 in China attended after-school tutoring classes in 2016, according to the most recent figures from the Chinese Society of Education, and anecdotal evidence suggests that this percentage has risen. The move threatens to decimate China's $120 billion private tutoring industry and triggered a heavy selloff in shares of tutoring firms traded in Hong Kong and New York including New Oriental Education & Technology Group and Koolearn Technology Holding Ltd. The regulators also consider that these companies may be exploiting parents’ wish for their children to get ahead at an early age by raising prices annually (double digit % per year), and thereby eating into families’ budgets. From this point of view, the recent aggressive regulatory stance against these companies makes sense.
Our view is that the Chinese after-school tutoring industry will never be the same again. Under the new regulations, companies will not be allowed to make profits and foreign capital will not be permitted to fund their operations (many of these companies are ADRs). It is likely that some will delist while others may opt to continue to operate under a different format. Based on the above now is not an optimal time to be a shareholder in this sector, although there could potentially still be some interesting opportunities in the vocational education sector, which caters to older students.
In conclusion, we believe that the regulatory changes need to be analysed case-by-case as the impact on individual companies and industries differs. For our holdings we believe the regulatory risks have been more than priced by the recent stock moves. The private sector accounts for 80% of job creation in China and we believe the government is committed to supporting it. However, there are individual industries that have serious issues which the government is trying to address with these recent regulatory changes.
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