Fund managers have had to react to regulatory measures aimed at sectors such as tech, gaming and tutoring. David Whitehouse reports.
In recent times, China has unleashed a salvo of regulatory measures against the technology sector, computer game makers and tutoring companies. The aim, say investors, is to safeguard hundreds of millions of people’s chances of achieving middle-class status.
The unpredictable nature and speed of the Chinese authorities’ actions have led to volatility in the country’s financial markets. At the same time, it’s worth noting that many sectors’ prospects seem unlikely to be affected by the government’s ideological stances.
One of the first signs of trouble came last November, when the planned initial public offering of Jack Ma’s technology company Ant Group was suspended. Then in April, Ma’s e-commerce giant Alibaba was fined US$2.8 billion in an antitrust investigation.
In July, the private tutoring industry was hammered by a ban on for-profit tutoring services that focus on high school and university entrance exams. The following month, computer game maker Tencent’s shares came in for a battering when state media referred to one of its games as “spiritual opium” – a comment that was quickly withdrawn.
“Investors are rightly worried in the short term due to the speed and scale of China’s intervention,” says Jerry Wu, manager of the China Stars Fund at Polar Capital in London. The crackdown has been a typically communist affair, he adds, with “low communication and low visibility”.
Still, says Wu, the uncertainty will blow over. China is setting up regulatory institutions to manage what was a “Wild West” technology sector, he notes, adding: “We are going to come out of this stage of the regulatory cycle.”
Regulation of the internet is not a case of tightening policy, but of introducing policy where none previously existed, says Baijing Yu, manager of the Comgest Growth China Fund based in Hong Kong. “Policies were designed for offline worlds,” she says, adding that it’s rare for regulators anywhere to get it right first time. Regulators don’t try to time their interventions to suit markets, but act according to their own agendas, she adds. The difficulty for investors when it comes to the education sector is that it can’t be priced, Yu says, which is why her fund avoids it. Policy remains “opaque” and the legal framework is “not as predictable as in the West”.
Common prosperity
Polar Capital’s Wu says China still has only 200 million to 300 million consumers, which he defines as people able to spend $20 a day on non-essentials. That leaves 600 million to 800 million people on low incomes who are yet to join the middle class, and the government’s priority is to get as many of them as possible to do so: “Common prosperity is what they aim to achieve.”
Many of those who will finally make it into the middle class are still in school, Wu says. In that context, teenage time spent playing computer games is seen as a threat to common prosperity. Gaming can be addictive, and can affect brain development in the under-14s, Wu says. “It’s not the government’s intention to stymy the growth of the industry,” he argues, and suggests that regulation will strengthen its long-term future.
Wu is not worried that hardliners may push the agenda too far. The private sector provides more than 80% of Chinese urban employment, and the Communist Party knows that this will be the main engine for getting people into the middle class. “They need the private sector to survive.”
China needs and wants foreign investors, according to the head of Mobius Capital Partners, the veteran emerging markets investor Mark Mobius. He remembers a time when accessing any kind of Chinese investment had to be done via Hong Kong – a fact that people forget, he says, now that they can buy directly into almost anything in China.
In many countries, it’s hard to tell where the real power lies, and China is not unusual in that sense, says Mobius. Beijing has clearly stated its aims and wants to reduce the gap between the rich and the poor, he contends. In that context, he sees companies that are large, dominant players in their industries as vulnerable.
The social aspect of ESG
Environmental, social and governance-based investing (ESG) developed in the West as a response to demands from stakeholders such as consumers, employees, non-governmental organisations (NGOs) and shareholders. In China, by contrast, top-down government policies have been the main driver, says Eli Koen, an emerging markets equities manager at Union Bancaire Privée (UBP) in London.
The recent focus in China has been on the social aspect of ESG, with common prosperity themes such as employee rights, data security and product safety, consumer wellbeing and protection of minors, Koen says. “A central pillar of this is to put the middle-income households at the core of society and support them in areas like education, healthcare and housing.”
The regulatory news flow from China is unlikely to be over, Koen adds. Indeed, he argues, the recent moves outlined above are by no means necessarily bad news. UBP, he says, always avoided tutoring companies “for exactly the same reasons that Chinese regulators have targeted them: they have very questionable educational value, they create a lot of financial pressure on families, they do not help income gaps and they take away much-needed playtime from kids”.
Likewise, UBP has avoided gaming companies because of potential addiction issues, especially for minors. Treating employees better, and moves on product quality and data privacy, have UBP’s backing. “We believe companies which take early steps in these areas are likely to make their businesses more sustainable in the long term,” Koen says.
According to Yu at Comgest, about 80% of Chinese parents can’t afford after-school tutoring, and some take out loans for their children’s education.
China’s view of ESG includes a concern with equality, says Polar Capital’s Wu. Demand has always existed for after-school tutoring, but the regime sees a conflict between a laissez-faire approach and the status of education as a public good. The danger as China sees it, he adds, is that the tutoring industry may widen the gap between the middle class and those below it.
Ideology-proof sectors
Prospects of an economic slowdown have added further complications for investors, though Wu argues that this is likely to be “a bump rather than a long-term slowdown”.
Lower growth was to be expected, according to Koen, as a result of rising domestic labour costs and more protectionist policies from the West that hurt China’s export-led growth model. “The rebalancing of the economy towards more domestic consumption and services may be a challenge for policymakers, but we do not see an obvious reason why China would fail at this transition,” he adds.
However, the increasing demands of state entities on data generated by companies concerns Koen, as does the growing involvement of the state in the operations of private companies beyond the regulatory framework. “We believe this could reduce the attractiveness of China as an investment destination in the long term,” he says.
Given the size of the Chinese investment universe, though, some areas may be shielded from both unpredictable ideological concerns and economic slowdown. Koen makes the case that renewable energy, electric vehicles, batteries, hydrogen, energy efficiency and storage, automation, waste management and recycling are all areas that can benefit from China’s carbon emissions target.
Mobius’s fund focuses on SMEs, and companies have to work with it on corporate governance to secure his investment. In China, a lot of regulatory risk can be avoided by investing in SMEs, he says. He cites medical equipment and higher education as potential growth sectors. Cram schools are the only ones affected by the clampdown, he says, and the money spent by parents will likely end up in higher education anyway.
Yu argues that consumer brands employ a lot of people and are relatively untouched by ideological considerations. In her view, medical devices are another promising sector. China’s decarbonisation targets are the most aggressive among emerging markets, and this will benefit solar equipment manufacturers, she adds.
According to Howard Wang, head of Greater China Equity at JP Morgan Asset Management in Hong Kong, regulatory changes are by “no means unique to China” and are not all market negatives. China’s ambition to be self-sufficient in semiconductor manufacturing and software development mean thats some industries will benefit from policy tailwinds in the medium to long term, he says. He sees technology, healthcare and consumption as structural growth areas.
Healthcare, automation and robotics are among the less ideologically sensitive sectors of the economy with strong growth prospects, says Wu at Polar Capital. The country has about 250 million people aged 65 or over, and he expects this to double in the next 20 years. This means huge demand for healthcare and medical devices, he adds. Healthcare is “macro-proof” and immune from ideological considerations: “It’s a very attractive growth area.”
The growing middle class will be a huge source of demand for dental care and healthy foods such as soya milk, Wu continues. China’s working population peaked in 2012 and will keep falling as the population ages, he adds. That means greater robotics capacity is “desperately needed” as the workforce shrinks and wage demands increase.
Chinese companies have moved up the automation ladder and are becoming as sophisticated as their Japanese and European peers, Wu says. In this industry, “it doesn’t matter where your ideological sensitivity lies”.
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