The China discount widens again

I’m back after a few days off, having retrieved my twins from summer camp in Vermont. It rained on them constantly, but they still had a lot of fun. It is also raining heavily on investors in Chinese stocks, and this is not fun, but it is interesting.

The China discount, part II

I wrote about the China discount a couple of weeks ago. My conclusion then — following experts who understand China a lot better than I do — was incomplete at best. 

Following the regulatory actions against the ride-hailing app Didi Chuxing — the most high-profile and severe example of a crackdown on companies in the overlapping worlds of technology, personal data and finance — it was clear that Chinese authorities were giving an absolute priority to central control of data and financial stability. Corporations and investors can pursue their own interests, but are circumscribed absolutely by those priorities, as defined by the Chinese Communist party.

That is, from an investor point of view, the easy part to understand. The hard part is knowing exactly how Beijing defines control and stability, and how big a discount to put on Chinese stocks as a result. There is a discount, it is growing, but it is hard to pin down.

In the past few days we have received new information about the CCPs definitions, and for some investors it has been a harrowing learning process. The CCP has made it illegal for tutoring companies to earn profits, raise capital, or list abroad. The shares of TAL Education Group, New Oriental Education & Technology Group and Gaotu Techedu (all US-listed companies) lost two-thirds or more of their value in one go. They are all down 90 per cent or more from their highs around the end of 2020.

This inspired perhaps some of the bleakest broker commentary I’ve ever seen. Here is Goldman Sachs:

Implications: the [sector’s] total addressable market to shrink to $24bn by 2025 from $100bn in 2020 . . . profits obtained from operating K-12 [tutoring] institutions may no longer be attributable to shareholders under the current contractual arrangement . . . our new 12-month price targets are reduced by 78 per cent on average lower vs their priors.

In other words: last one out, please turn out the lights.

In what would have been bigger news, if not for the evisceration of an entire sector, property management companies are also feeling the squeeze, as Chinese regulators issued a statement at the end of last week saying they would “improve order” in the industry. Stocks in that sector fell 15 per cent or more on Monday. And food delivery app Meituan fell 14 per cent when the government signalled its resolve to protect the rights of gig workers. 

What we have leaned, I think, is that the scope of the CCPs desire to control is wider than we thought: we have to add a strong (but vague) concern for social stability to the concern for financial stability and control over personal data. 

Shuli Ren summed it up neatly in a column in Bloomberg (emphasis mine):

[The CCP is ] reining in the power of its tech titans and boosting start-ups; protecting social equality; and making sure the cost of living in cities isn’t so high that families aren’t willing to have children . . . If you’re going to invest in China, you’ll have to do it through the capital markets it’s developing. That won’t only strengthen the domestic economy, it will also allow Beijing to make sure the capital goes to industries it wants to develop and stays away from areas it deems a threat to the common good. 

At this point it is perhaps worth deflating the notion that nothing like this ever happens in America. Some of you will remember when president Barack Obama took on the American for-profit college sector, passing the “gainful employment” rule. It took away eligibility for government education loans from schools whose graduates did not land well-paying jobs. The sector was decimated. At least two publicly listed companies (ITT Technical Institute and Corinthian Colleges) declared bankruptcy. Now, you may think many for-profit colleges were simply frauds (I think this). But the point is that the American government can, and occasionally does, all but end industries. One government’s fraud is another’s social “disorder”. 

Is the China discount growing as a result of the latest crackdowns? International investors has net sales of $2bn in Chinese equities on Monday alone, according to the FT. One investor with a famously hearty risk appetite has seen enough. From Bloomberg:

Cathie Wood is exiting Chinese stocks as Beijing’s crackdown on private businesses sows uncertainty across markets . . . The head of Ark Investment Management got rid of shares in tech behemoth Tencent Holdings Ltd and property site KE Holdings Inc every day last week, according to data on the firm’s trading activity . . . Her largest fund, the ARK Innovation ETF, now has only 0.32 per cent of its $23bn in assets invested in Chinese companies, compared to 8 per cent in February

How is this affecting the valuation of Chinese equity markets broadly. Is the China discount growing? Certainly, the relative price/earnings valuations of Chinese indices are falling behind global indices, but the trend is long-term and quite gradual:

To make this a bit clearer, here is the blended price/earnings of the mainland CSI 300 and Hong Kong’s Hang Seng, divided into the MSCI world P/E, to generate an estimate of the China discount since 2005:

But this should not give anyone the impression that Chinese markets are undergoing a slow rout. They are, in absolute terms, doing just fine. Consider the long-term chart of the CSI 300:

It is hard to imagine a party official looking at the chart and thinking that there is a danger that the recent crackdown will kill the capital markets golden goose. The goose appears to be in fine health. 

In this context it is instructive to think about what might be happening to the least politically or socially charged stocks in China. Are they trading at a discount to global peers? The best example I would think of here was mobile telecoms. So I banged out the valuations of some telecoms companies in the developed world, emerging markets, and in China:

What is interesting here is that on a price/earnings basis, the big Chinese telecoms companies trade at a discount, but not a universal one: China Telecom has the same PE ratio as AT&T, for broadly similar growth characteristics. 

The big discount is in enterprise value/Ebitda (for the uninitiated, this ratio is profits before taxes, financing costs and depreciation divided into equity value plus net debt — a ratio designed to take out the anomalies of different companies’ capital structures). I’m not entirely sure why Chinese telecoms are so cheap on this metric, except to say that they carry less leverage than global peers and they have higher investment levels and therefore depreciation. 

Given these differences, it seems to me the Chinese companies should trade at higher PEs. More investment should lead to greater long-term growth; lower leverage means financial flexibility (including the option of increasing earnings with more leverage). But that raises another question: what are the political ramifications for a Chinese company that decides to reduce investment, or lever up its balance sheet, in the current environment?

The China discount, as far as I can tell, applies even to this most vanilla of sectors. 

One good read

How quickly is global warming happening? Don’t ask a meteorologist. Ask a farmer. My colleague Emiko Terazono did in this excellent long read.