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The rapidly evolving regulatory landscape in China has persistently populated financial market headlines this summer. We think investors should attempt to dig below the superficially sensational news to understand the motivation and the fundamental impact of what’s happening. Naturally, bearish sentiment has impacted stock prices, but has also created a number of very interesting opportunities. Everyone will come to understand that China remains a fertile ground for longer-term investing, in our opinion.
We think that there are some lines to be drawn at a very high level that link some of these regulatory changes.
China’s economic “miracle” of lifting the vast majority of its population out of poverty has come at a breathless pace relative to the similar development paths of more mature economies. That pace has left gaps where commercial enterprise has been allowed to thrive relatively unfettered by regulation. In part, the flurry of new rules can be seen to be a catch up to create a better long run environment for many industries. In a sense, the impetus has shifted from just growth to both sustainability and growth. Left unchecked, some companies have taken full advantage of grey space, but now found some of their activities to be on the wrong side of the increasingly clear hard lines of regulation.
One frustrating aspect of new regulation in China is the method by which changes to industry rules happen. There is very little in the way of iterative, public hearing type processes, and analysts are often restricted to the parsing of political signs to anticipate changes. Often we know that an industry is in the spotlight, but putative changes are not bounced off the walls of popular and market opinion, and frankly they are not subject to a very transparent political process. In addition, many new regulations have lacked specific implementation detail, prolonging uncertainty. And as we know, financial markets everywhere hate uncertainty and surprises.
Taking a step back, whilst criticism for implementation may be valid, the goals are not too dissimilar from much that is happening in the developed world:
One interesting aspect relates to timing. There have been many pops of regulatory attention being focused on certain industries in the last few years, ranging from housing, to liquor, to mining. But it does appear that rather like popcorn, the pace of the popping has picked up.
We think that the perceived success in dealing with the medical and economic consequences of the pandemic, and the relative stability of the Chinese economy, has created a window of opportunity to increase the cadence of micro tightening. As the delta-based infection rates increase in China, albeit from a low level, and the macro environment turns a little more challenging, we think that the micro pops will start to be further spaced out.
A widely known, and incredibly predictable challenge for China, is demographics. The population is rapidly aging. The fertility rate is low. The cost of raising a larger family can be daunting, particularly as it relates to the “three mountains” of costs associated with childcare – education, healthcare and housing. In part, some recent changes are designed to address those challenges, and attempt to create a more equitable society.
Here is our brief overview of these impacted areas.
Education – Pushing for Decent, Affordable and Quality Education
Compulsory education has long been understood to be a sensitive area. Private involvement in K-9 schools has already been severely constrained. Parents’ desire to secure an advantage for the important university entrance exam led to a burgeoning after school tutoring market. There is no doubt that the industry had some excesses and bad behavior. The latest regulation effectively calls into question the whole private after school tutoring model, a core part of two reasonably well known ADRs –TAL Education Group ADR (TAL) (0.00% of Strategy assets*) and New Oriental Education ADR (EDU) (0.00% of Strategy assets*). On the other hand, tertiary education is an area where the government encourages private participation. In part, this is to allow resources to be diverted to provide good quality K-12 education. Public universities and colleges are being told to divest their private offshoots, creating very interesting M&A opportunities for China Education Group Holdings Limited (CEG) (2.36% of Strategy assets*). In fact, over the weekend when the after school tutoring regulations were revealed, the company announced a sizeable acquisition. We think that it is very unlikely that this would have been approved if the tertiary education sector was being targeted. CEG trades at 14x 12M Forward (FWD) (consensus) earnings, with a very high degree of visibility and great cash flow (fees paid up front). Earnings per Share (EPS) Compound Annual Growth Rate (CAGR) for the next two years is approximately 23% before considering likely accretive acquisitions.
Healthcare – Striving for Accessible, Affordable and Quality Healthcare System
The government knows healthcare costs will be a challenge as the population ages, and the key issue is to provide the triumvirate of quality, access and affordability. This sector has already been radically transformed to help achieve this. I will spare you the details, but it is about providing effective drugs, in a cost efficient manner and encouraging innovation and efficiency in the delivery of medical services and drugs. That is why the VanEck Emerging Markets Equity Strategy owns market leaders such as Wuxi Biologics Inc. (1.08% of Strategy assets*), Pharmaron Beijing Co., Ltd. (1.13% of Strategy assets*) and Zai Lab Ltd. (0.83% of Strategy assets*). Delivery of services has to be convenient and cost efficient – that is why we own Alibaba Health Information Technology Ltd. (1.09% of Strategy assets*) – a leading provider of supplements, prescriptions and consultations online.
Housing – Making Property More Stable and Affordable to the Public
Property is always sensitive in China – it really is more a store of wealth than equities, historically. There is a goal of stability here. Property developers are fairly highly leveraged, so the government has drawn some lines in the sand to keep those leverage levels under control. It has also provided a decent length of grace period for this to happen. Evergrande, which has liquidity issues, IS NOT the sector. We would not be surprised to see moves towards implementation of property tax or mandates of affordable housing, in the future. We do not own any developers, but with many examples of sub 5x multiples, these could be attractive for value investors. What we do own is one of the property management companies, A-Living Smart City Services Co., Ltd. (2.06% of Strategy assets*). The company has not been left out from scrutiny, but this has mostly been a reiteration of previous guidelines around social security contributions for employees, advertising in common areas etc. We believe that A-Living is already broadly compliant, and market weakness is an overreaction. It trades at 12.5x 12M FWD with EPS 2 year CAGR of 35%, with a high degree of visibility as a very substantial part of their pipeline comes from parent companies and government contracts.
The ANT issue was pretty specific to its business model, which was in part sourcing loans and passing its risk onto commercial banks. Effectively, the government simply said that the playing field has to be levelled. Meanwhile, the government has also taken aim at potentially abusive monopolistic practices in Alibaba Group Holding Ltd. (3.42% of Strategy assets*) and its core e-commerce business. But Alibaba is now trading at historic lows of about 18x 12M FWD earnings, and if you back out their other businesses and investments at sensible prices, the core e-commerce business looks fundamentally undervalued to us. Tencent Holdings Ltd. (4.46% of Strategy assets*) went through the regulatory hoops for its video gaming business in the recent past. We think that there may be further regulations to address children’s video gaming habits, but we also believe that this is well understood and very containable.
The Bottom Line Is… that there can be specific impact on various companies and industries, but that is best analyzed through fundamental, rather than sentimental impact. This is not about Variable Interest Entities (VIEs) or accounting related issues – those are different topics. Nor is it about geopolitical tensions (which are not going away). It is about specific impacts which can be good or bad for individual companies. Clearly, we believe that the impact is either not bad, not meaningful, or has been more than incorporated into the valuations being asked, in the companies that we own. We are not complacent, but we do think that there are tremendous opportunities being created by some indiscriminate selling. After an active YTD, we feel very excited about our holdings and strongly believe that we are well positioned with forward-looking, sustainable and structural growth opportunities in a diversified portfolio that fits nicely into the evolving emerging markets investment landscape.
Please note that VanEck offers investments products that invest in the asset class(es) or industries included in this commentary.
* All company weightings are as of 31 July 2021. Any mention of an individual security is not a recommendation to buy or to sell the security. Strategy securities and holdings may vary.
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