The Case for China
There have been several new regulations in China in recent months across a broad range of industries, including financial services, ecommerce, cybersecurity, ride-hailing, food delivery, real estate, education, and e-cigarettes. These regulations have largely been aimed at protecting national security, enhancing technological innovation, limiting monopolistic competition and promoting education. In light of these regulatory changes many investors have been questioning the validity of an investment in Chinese companies, which has been exacerbated by the increased volatility of share prices, seeing billions of dollars of market value eroded in the past few months. The below article provides some insight into the recent Chinese regulation.
The past decade has seen China successfully meet its goals of alleviating poverty and improving living conditions. Approximately one hundred and sixty million people have been lifted out of extreme poverty over the past decade. The shift to urban areas has also been accompanied by increased employment, with an estimated sixty million jobs having been created in urban areas in the past five years.
The policies that enabled the rapid economic growth have clearly played a significant role in achieving the strategic goals of government over the past decade, but it has become clear that unchecked economic growth has come at the cost of increasing inequality. China’s latest five-year plan attempts to address some of the challenges created because of the unchecked economic expansion. Emphasis has been placed on factors such as healthcare, childcare, fertility, education, and the environment more than previous plans, with the government focusing on achieving common prosperity for its citizens.
It is a common perception that Chinese authorities are targeting technology companies with a regulatory crackdown but the reality is that most governments around the world are concerned with monopolistic and anti-competitive behaviour of large technological companies.
Anti-monopoly legislation dates back to the nineteenth century and most countries have some form of anti-competitive legislation in place. The United States established the Sherman Act in 1890, which is aimed at being a “comprehensive charter of economic liberty aimed at preserving free and unfettered competition as the rule of trade”. The Sherman Act was recently enforced upon Microsoft in the 1990s, where it was discovered that it had attempted to gain monopolistic power over internet browser software.
More recently, the American Supreme Court in 2019 allowed a large class-action lawsuit alleging violations of antitrust law to proceed against Apple. The Justice Department also began a broad review of potentially anticompetitive behaviour in 2019 as well by “market-leading online platforms” which included antitrust investigations into alleged monopolistic practices by Google. In addition, Google has recently settled an antitrust lawsuit in France after paying $270 million in fines and agreeing to amend some of its business practices.
This is similar to the $2.75 billion fine that Alibaba paid for monopolistic behaviour in April 2021 (To put the fine amount into perspective, this was approximately 4% of Alibaba’s 2019 sales). The difference between China and other countries is that China has only recently enacted anti-monopolistic legalisation, with anti-monopoly laws only passed in 2007, years after the Chinese technology companies were founded (Tencent and JD.COM were founded in 1998 and Alibaba was founded in 1999. The State Administration of Market Regulation in China, which has to apply the anti-monopoly laws, was only established in April 2018).
China has recently noticeably stepped up supervision over its internet companies, which has largely been misunderstood as a regulatory crackdown and a signal that the country wants to punish those companies as a warning. Instead, upon deeper examination it is clear that the aim is to allow for the development of orderly and sustainable development of internet firms, which protects consumers and allows space for smaller competitors to develop.
Although there may be uncertainty of the approach that Chinese authorities may take, it is clear that regulations imposed are aimed at genuinely establishing rules and building an environment conducive to protecting competition and not aimed at cracking down on private companies. Effective regulation is hard to achieve, in particular when it comes to the internet sector, where regulators need to balance several competing objectives.
A study on the significant declines in Chinese equities over the past twenty years is presented in the table below with the major news stories at the time of decline, how long they lasted, how much the MSCI China index fell from peak to trough, and the subsequent returns included.
Source: Goldman Sachs, Cederberg Capital, Bloomberg.
The table above indicates that for each of the past sixteen notable declines in Chinese equities, the subsequent one, three and five-year returns were positive, with the index averaging a cumulative return of 119% over the subsequent five-year period. These returns highlight the importance of having an investment approach that is long-term focused and not being derailed by temporary turbulence.
The long term impact of the regulatory changes in China remains uncertain, however the recent negative returns experienced by Chinese equities as well as the current valuations indicates a strongly positive future for long-term investors.
The graph and table below indicate that over the past twenty years Chinese equities (proxied by the MSCI China Index) have provided far superior returns in comparison to global equities (proxied by the MSCI All Country World Index) as well as American equities (proxied by the S&P 500 Index). In addition, the graph below illustrates the additional volatility that accompanies an investment in Chinese equities, with global and American equities providing more smoothed returns over the long term. Therefore, an investment in Chinese equities may be more risky and turbulent that an investment in global or American peers, however it is clear that this additional risk translates into superior returns. Lastly, it is important to consider that the risks accompanying a Chinese investment evolve over time from the SARS virus concerns in the early 2000s to regulatory concerns most recently.
Source: Morningstar Direct. IndexCumulative US$
Source: Morningstar Direct.
Prolonged periods of poor market performance can take a toll on even the most patient investor, however the key is to ride out these bumpy periods, remain patient and trust in your investment process. Although the long term impact of the regulatory changes in China remains uncertain, it is likely that share prices have been driven well below fundamental value as a result of the regulatory uncertainty which bodes well future returns. Lastly, as Warren Buffet says “Be fearful when others are greedy and greedy when others are fearful”.