China’s evolving regulatory landscape

Dale Nicholls’ thoughts on China’s evolving regulatory landscape

I wanted to personally share my thoughts on the sharp sell-off we saw in Chinese equities earlier this week and hopefully, put the regulatory news flow into perspective.

The recent downturn in the Chinese stock market was primarily driven by the government announcing an extensive regulatory overhaul of the education sector last Friday.

These new policy measures have a devastating impact on the After School Tutoring (AST) space – not only will classes be significantly limited but they will need to be non-profit, cannot be funded by listed entities, and foreign ownership will be restricted. It appears the overall aim of these reforms is to reduce the cost of education on children and families.

From a portfolio perspective, the trust has a relatively small exposure to the education sector, with a small position in China Online Education – a company that provides a platform for foreign teachers to teach students English.

While we have been wary of potential regulatory changes to the AST segment and I exited from other AST stocks earlier this year, I didn’t factor in the likelihood of a ban on overseas teachers – clearly a misjudgement on my part.

Naturally, a key concern for investors is how these education reforms coincide with the heightened level of policy developments we have seen in China over the past six to twelve months. Industries such as mobile payment providers, consumer finance and ecommerce names have been targeted by regulatory changes relating mostly to antitrust and data security issues.

There is particular sensitivity to overseas listings by data-heavy companies, and we have seen with the recent listings of Didi. This seems likely to drive many more companies back to listing on the Mainland and Hong Kong.

From a timing and historical perspective, it is certainly not the first time we have witnessed heightened regulation in China. We only need to cast our minds back to 2018 when the government felt the younger generation was spending too much of their time playing online games and as a result halted new gaming licenses.

This was clearly a factor driving a near 50% correction in Tencent’s stock price before rebounding. Markets dislike uncertainty but we have since seen Tencent’s shares rally 200% since the low in October 2018 to their high in January this year and up 77% using yesterday’s close post the clarification of these “rules”. While not without some risk, history teaches us that these times can be the most opportune to invest – attractive valuations coupled with conviction in a company’s business model, management team, and the long-term opportunities.

In terms of valuations, we are seeing many companies in the tech space now trading at historical low valuations, and at significant discounts to global peers. We acknowledge that there is potential for business models to change and are accordingly, adjusting down our expectations around monetisation levels in certain companies. Having said this, investment is all about risk-reward and for many names, this is looking favourable after recent moves.

Although it is tempting (One could even argue logical) to connect the regulatory changes to the internet sector to what has happened in the education segment, we see them somewhat independently. The thrust of the regulatory changes in the internet space has been around anti-trust and data security, policies which have been in the works for some time and in many ways have lagged other countries in terms of basic “infrastructure”.

Politically, education is a very sensitive area and also represents one of the so-called “Three Mountains” – areas where cost pressures can exacerbate income gaps in society (clearly, an issue not just in China but a global problem). The other two “mountains” are medical services and housing. We see regulation around these three areas becoming more prominent – obviously something we are very focused on as investors. Given our weighting in healthcare we are watching developments closely, but my sense is that policy moves are already quite progressed (for example, most price cuts are focused on generic drugs versus the government’s goal of developing home-grown innovative drugs).

Whilst we can’t predict the details of every single policy move (such as the recent one around education), it is important to keep in mind the historical context and the longer-term goals that have been laid out. China has clear priorities around economic growth including doubling its GDP per capita (once again) by 2035. Nobody could argue that a vibrant and healthy private sector is essential to achieving this aim.

Priorities around innovation are also clearly rising – many of the companies in the sectors we are talking about are not only big employers and drivers of growth, but also drivers of innovation. Also, China has made no secret about its goals around developing its capital markets and internationalising the RMB. Clearly, the creation and evolution of a stable investment environment – for both domestic and foreign investors – has to play a part.

In this regard, we have already seen press statements from policy makers seeking to calm markets and last night, the regulatory body (CSRC) held a meeting with banks and financial services companies to highlight their rationale for these specific AST reforms; the ADR market and the HK/China markets have rallied on the back of this news.

I’d like to finish off by reiterating that government regulation is a constant in China – any investor must accept and incorporate this into one’s risk/reward framework. Many new policy initiatives are still evolving and certainly can cause uncertainties which is why it is key for me and Fidelity’s analysts to continue to incorporate this factor into our assessment of long-term business prospects for a business, and how corporate management teams and their business models are positioned. Investing at the end of the day comes down to risk reward and with the correction we have seen, this is tipping in our favour. Yes, sentiment is poor, but it usually is at the most opportune times.

Take care and all the best,

Dale

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