Investors rethink China strategy after regulatory shocks

After four days of heavy selling in Chinese stocks, regulators in Beijing decided it was time to offer some reassurance to Wall Street. But some investors have still been left figuring out whether to double down or flee.

In a hastily arranged call on Wednesday evening, Chinese regulators told a dozen or so executives from global investors, heavy-hitting banks and Chinese financial groups not to fret about the shock overhaul of the country’s $100bn private tutoring industry. Investors should not worry about intervention to curtail profitmaking in other companies, they said. Rather, China remained committed to allowing companies to access capital markets. 

The message did not stick. Tech stocks in the country have wrapped up their worst month since the financial crisis of 2008. “Clearly there will be more [regulatory intervention] to come,” said one person briefed on the call. “That much was obvious to everyone.” 

Now, foreign investors in China have been left nursing huge losses, and anxious over where, after education, regulators might turn their attention next. They must decide whether the drop in stocks is an opportunity to double down on a fast-growing economy or a sign that unpredictable political risk outweighs potentially lucrative returns.

“The political risk factors of investing in China have grown exponentially in the past 18 months,” said Dominic Armstrong, chief executive of Horatius Capital, which runs a geopolitical investment fund. “People learned the hard way in Russia and they’re learning the hard way in China.” 

Tough lesson

Following a leaked memo just over a week ago suggesting Beijing was planning to clamp down on education companies, the market sell-off was sharp.

It was led by a drop in education stocks that, according to one Gavekal analyst, made for “some of the most traumatic viewing since the charts of Lehman’s bonds”. TAL Education, Gaotu Techedu and New Oriental Education, which are listed in New York, all fell close to 60 per cent in the first hour of trading on July 23.

Further jitters came on Tuesday when Tencent, one of China’s biggest tech groups, announced its flagship WeChat social network had suspended user registrations as it upgraded security technology “to align with all relevant laws and regulations”. 

Nerves have pummelled Chinese tech groups listed in New York, taking the Nasdaq Golden Dragon China index down more than 20 per cent in July — the worst month since the global financial crisis. 

In Hong Kong, the Hang Seng Tech index fell almost 15 per cent, dragging the broader Hang Seng benchmark almost 9 per cent lower as Chinese internet giants Tencent and Alibaba fell 18 and 14 per cent, respectively. 

Big institutional investors have driven the selling, according to strategists at JPMorgan Chase. Meanwhile Ark Invest star manager Cathie Wood has also been slashing her China holdings. The $22.4bn Ark Innovation exchange-traded fund, which held an 8 per cent allocation to China shares in February, has now almost completely exited Chinese stocks, according to the company’s website.

But some have stepped in for a potential bargain. “We have been net buyers,” said a fund manager at a $15bn Asia-based asset manager. “It is unheard of to see these types of moves . . . You’ve got to buy them, unless you think the entire world is going to crash and burn.”

National objectives

The crackdown on education marks part of the Chinese Communist party’s attempts to address falling birth rates by removing some of the perceived financial obstacles to having children. The rules will ban companies that teach school curriculum subjects from making profits, raising capital or listing on stock exchanges worldwide, and from accepting foreign investment.

This sector is dominated by three large US-listed groups — TAL Education, New Oriental Education and Gaotu Techedu — which have enjoyed soaring valuations in recent years and drawn billions of dollars of backing from some of the world’s top investment firms such as BlackRock and Baillie Gifford.

Private rivals like Yuanfudao and Zuoyebang, which have held multibillion-dollar funding rounds in recent years, are backed by groups including Tencent, Sequoia, SoftBank’s Vision Fund and Jack Ma’s Yunfeng Capital.

The government intervention came shortly after anti-monopoly and data security measures against some of China’s largest tech companies. Last November the $37bn blockbuster initial public offering of Chinese payments group Ant was torpedoed by Beijing regulators, and its controlling shareholder — Alibaba founder Ma — disappeared from public view for several months.

In the past few months Beijing has also been expanding its influence in to the domestic online sector. In April it fined ecommerce group Alibaba $2.8bn for abusing its market dominance, and opened an antitrust investigation into Meituan, the takeaway delivery and lifestyle services platform. 

And earlier in July, Chinese regulators announced an investigation into possible data security breaches at Didi Chuxing, less than a month after the ride-hailing app raised more than $4bn in a New York listing. Its shares have dropped two-fifths since then.

Baillie Gifford, the Edinburgh-based fund manager with £352bn in assets under management, is the second-largest shareholder in US-listed TAL and has made big bets on China’s tech sector.

“It’s not saying we like the geopolitics or the national politics or anything like that,” Baillie Gifford fund manager James Anderson told the Financial Times in June, referring to its decision to add exposure to China in recent years.

But potential gains are too compelling to ignore, he added, pointing to “the excitement we see around businesses, the ambition levels among Chinese entrepreneurs, and the relationships we can build with the individual companies”. 

Baillie Gifford declined to comment this week on the latest developments in China.

The new restrictions for private tutoring companies prohibit them from accepting foreign capital through “variable interest entity” structures — the model that many big Chinese tech firms have used to list abroad for two decades. The VIE structure, which allows global investors to get around controls on foreign ownership in some Chinese industries, has never been legally recognised in China, despite underpinning about $2tn of investments in companies like Alibaba and Pinduoduo on US markets. 

In response to Beijing’s restrictions on China-based companies raising capital offshore, on Friday the US Securities and Exchange Commission announced that China-based companies will have to disclose more about their structure and contacts with the Chinese government before listing in the US. 

“I worry that average investors may not realise that they hold stock in a shell company rather than a China-based operating company,” SEC chair Gary Gensler said in a statement.

Widening crackdown?

The education crackdown sparked fears the VIE ban could be extended to other sectors.

Revoking the rights of Chinese companies to use VIEs is seen as China’s nuclear option. On Wednesday, Beijing regulators sought to reassure investors that it would not target VIEs more widely. But one Wall Street executive briefed on this week’s call with regulators said “it was more about what they didn’t say, there were questions about the VIE structure they didn’t address”.

The consequences of restricting VIEs in sectors outside of education would be so severe that some are confident Beijing would not eradicate them completely.

“The government will allow the VIE structure to survive, but one thing is clear: if a company wants to use the VIE structure to circumvent certain regulations then that is not going to work,” said Min Chen, head of China at $8bn emerging markets specialist Somerset Capital Management.

Rather than selling out of China altogether, some investors say they are focusing on trying to select stocks that are in line with the government’s strategic priorities. 

“Companies such as taxi-hailing groups or community group buying businesses, where their model is to use their competitive pricing advantage to squeeze out smaller players are likely to find themselves vulnerable to more regulation,” said Chen. “There is also the potential for winners in this environment, such as domestic leaders in the tech space and semiconductor producers . . . as well as companies that are exposed to mass consumption.” 

Alice Wang, a London-based fund manager at €2.7bn Quaero Capital, agreed that investors will need to switch to betting on sectors that are “important to China’s long-term economic future . . . areas like renewables and industrial automation companies that drive the ‘Made in China’ narrative.”

David Older, head of equities at €41bn asset manager Carmignac, echoed these sentiments and said he likes sectors such as semiconductors, software, renewable energy, healthcare and electric vehicles. He is overweight China and has been adding to his positions this week: “It’s a great buying signal when you see strategists saying that China is uninvestable.”

Trying to align yourself with the government’s strategic objectives “is the only way you can sleep at night”, said Horatius Capital’s Armstrong.

Chinese government intervention is about addressing its “demographic time bomb,” he said. “This is a Chinese problem and there will be a Chinese solution. You can come along and be a passenger if you want, but the ride is not going to be smooth.”

Additional reporting by Eric Platt in New York