Specialist in Asia Pacific, Japan, China, India and South East Asia and Global Emerging Market equities.
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Stewart Investors manage investment portfolios on behalf of our clients over the long term and have held shares in some companies for over 20 years. They launched their first investment strategy in 1988.
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Since 2020, China started rolling out comprehensive regulations for its internet sector, since referred to a crackdown. Among these regulations were restrictions covering anti-monopoly, restrictions relating to data security & privacy, minor & labour protection and restrictions on overseas equity raising and listings.
Fast forward to this year, on 16 March, China’s FSDC (Financial Stability and Development Committee), chaired by China’s Vice Premier Liu He, pledged to restore market stability, and specifically for China tech, the FSDC insisted to push and complete the Fintech rectification as soon as possible.
While holding the view the market has priced in most headwinds, we see the mid-March meeting as an early sign of easing of the regulatory crackdown. We have been accumulating exposure to Chinese tech on dips, focusing on highly rated national champions with intrinsic credit profiles intact.
Despite high levels of market noise and price volatility experienced by the Chinese tech sector over much of the past two years – or perhaps because of it - balance sheets of major Chinese tech firms remained prudent.
We also believe higher rated Chinese tech firms could outperform lower rated firms already facing challenges. By combining our deep understanding of relevant markets, including credit, political and social context, the team aims to capture attractive alpha generation entry points for the Chinese tech sector.
The storm
The crackdown on the local technology sector by the Chinese government resulted in an elevated level of regulatory scrutiny for the sector, reflected in a series of headlines at the time:
Alibaba: Suspension of Ant Group’s IPO in Nov 2020, and RMB18bn (~USD2.75bn) Antitrust fine.1 2
Meituan: RMB3.4bn (~USD530mn) Antitrust fine with various measures imposed on riders’ payout structure and insurance.3
Tencent: Restrictions on minor gamers and in-game purchases as well as ban on new apps and gaming licenses.4
As market volatility escalated, investor confidence in the tech names naturally eroded, and a more defensive stance towards names in the sector became warranted. Our team focused on identifying firms with solid industry moat, healthy cashflows, and adequate cash balances that would be able to endure near term headwinds.
While regulatory changes were expected to delay asset monetisation of tech firms and compress margins over the medium-term, we took the view that highly rated national champions would have adequate financial buffer to absorb the expected impact and deliver earnings despite the near-term headwinds. We expect the regulatory overhang to pose additional challenges for lower-rated tech firms already facing operational challenges related to their loss making segments or debt funded balance sheet expansion.
Historically, the senior curve for Chinese tech firms traded on average ~45bps above similarly rated US tech peers. However, we saw risk premiums beginning to rise in 2021 as China’s regulatory storm started to escalate.
Source: Bloomberg and First Sentier Investors data as of 14 September 2022.
By March 2022, Chinese tech firms were trading at attractive risk premiums, at a significant discount compared to their US peers.
The Path Ahead
We expect Chinese domestic affairs – employment, economic recovery and zero-Covid policy – will remain front and center in the near term from a regulatory perspective, as the mid-October 20th National Party Congress fast approaches.
While there is always the possibility a surprise geopolitical shift could create new headwinds for the sector, our base-case expectation is for a period of reconciliation, recovery and growth, as the sector emerges stronger and more resilient post the crackdown.
2 https://www.ft.com/content/c1ee03d4-f22e-4514-af46-2f8423a6842e
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