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The Great Fall of China

By Justin McNichols, CFA

The consensus seems to feel Chinese equities are uninvestable. Read why the herd could be wrong.

The year was 2019. Chinese equities were in the middle of a strong year. Nearly half of the world’s largest technology companies by market capitalization were based in China. The Chinese government was on a mission to catch then surpass U.S. technology companies in important segments like artificial intelligence and quantum computing. President Xi Jinping implemented the “Made in China 2025” initiative, while committing to spend well over a trillion dollars to assure the mission was successful.  Fast forward to the end of 2021, and the situation is far different.

After 2021, investors seem to feel the Chinese government’s mission is to control and possibly destroy their own large technology companies. Now the market capitalization of the five largest Chinese technology companies combined is smaller than one U.S. company, Google. The catch and surpass tagline may have to be edited to “Made in China 2035.” Now China faces several fiscal, monetary, social, and health concerns as 2022 begins. From an investor standpoint, the consensus has vacillated somewhere between panic selling and calling the entire country “uninvestable.” 

What happened between 2019 and 2021 to cause the Chinese equity market to become an investing yard sale?

As a real estate bubble fueled by excess debt and housing supply was slowly and quietly building through 2020, the government appeared to turn on technology companies in the fall of 2020, starting with silencing and punishing outspoken government critic Jack Ma of Alibaba. Alibaba’s Ant Financial IPO was essentially canceled by the Chinese government, and investigations were opened against the company – a not so subtle message to large technology companies. A few months later, Chinese equities would peak and start a 36% correction. Carving out the tech/media/internet area, this cohort has fallen nearly 70%.

Although there are a few widely varying explanations for this epic correction, the part of the blame related to government intervention focused on three main targets – data control, large company power and anti-competitive behavior, and consumer protection.

First, the government believes data is arguably the most important asset to the country. They want to assure that data stays within the country and is not used in a negative way by Chinese companies when marketing to their citizens. As a result, to assure data stays within the country, they have a plethora of rules about U.S. ownership of Chinese companies in various industries from biotechnology (no sharing of newly invented compounds) to performing arts groups (no sharing of professional juggling secrets). Plus, Chinese security law states “audit papers and working files by listed Chinese companies shall be stored in China, and shall not be sent abroad.” Additionally, the Personal Information Protection Law (PIPL) was put into effect on November 1, 2021. PIPL attempts to assure consumer data is processed and collected for a clear purpose with minimal impact on the consumer’s rights and interests. Users need to be notified when data is collected, and opt-out options must be visible with expiration dates. Parts of the PIPL actually sounds similar to what the U.S. and Europe are implementing.

Second, the Chinese government wants to defend against companies (or CEOs like Jack Ma) having too much power. These companies have been recently, and not subtly, reminded that they are domiciled in a Communist country with a Socialist market economy. The reminders have come in the form of major monetary fines, with corporate officers of these companies coincidentally announcing large charitable gift intentions.

Third, on the consumer protection front, the government has attacked industries that, in their opinion, either damage consumers financially or socially. Examples on the financial side, are ride-sharing companies and the food delivery industry, where the government questions their pricing. On the social side, for-profit education and video games have been targets. The for-profit education industry was more or less eliminated by the government as they want to reduce the amount of excess schoolwork for children and cost for parents, while reducing the amount of their spare time directed toward video games.

These targeted governmental changes have been unannounced and swift. But as the country also deals with a weak real estate market and zero tolerance COVID rules, the cumulative effect has been a negative one on their equity market.

In addition, Chinese regulation uncertainty is rampant throughout the investing community. Investors wonder when the government will tone down the attacks and which industries, if any, are next. With billions of dollars of equity value lost, Chinese citizens have not only lost wealth, but many companies have slowed their historically high hiring growth rates. This has caused the government to take notice. At their recent annual Central Economic Working Conference (CEWC), for the first time the government mentioned the recently elevated unemployment rate for recent college graduates. They stated a goal to “better solve college graduates’ unemployment problem.”   

Along with the real estate industry’s problems, regulation uncertainty, lost wealth, and higher college graduate unemployment, China’s ultra-strict zero tolerance rules for COVID continue to cause the economy to repeatedly pause then begin to grow then pause, without achieving an actual upcycle.  Finally, the perceived Chinese ADR (American Depository Receipts) delisting risk has caused a capitulation situation as U.S. based investors have recently panicked out of large Chinese technology companies, fearing a delisting derived from either the U.S., China, or both parties.

All of the news coming out of China over the past three to five quarters has been enough for many investors to panic sell and call China “uninvestable.”

We believe the selling and negative sentiment has reached a crescendo, and investors are overlooking the potentially positive environment for Chinese equities in 2022 and beyond. How do we know this? The Chinese government told us, the calendar told us, and valuations are telling us.

The Chinese government – Monetary, fiscal, and social tailwinds.

During a seven-day period from December 3rd to the 10th, the Chinese government announced a number of positive actions for 2022. On the monetary side, the government cut the bank required reserve ratio (RRR) by 50 basis points on December 3rd. With an excess amount of real estate debt maturing in February to April 2022, we believe the probability is high of another RRR cut in the first quarter of 2022. By lowering the RRR, banks are able to inject permanent funds into the economy via loans, especially to smaller businesses. Additionally, during the December 6th annual Politburo meeting, which is the 25 member group of top officials who oversee the Chinese Communist Party, the words “stability” and “growth” appeared in their meeting notes more than in 2020, while mentioning accelerated local government bonds at their State Council. On the fiscal side, at the previously mentioned CEWC meeting on December 8th-10th, policymakers distinctly talked about their 2022 goal to “accelerate fiscal expenditures and front-load infrastructure investment.” Socially, they also mentioned focusing on the recent college graduate unemployment problem. From a commonsense standpoint, are highly educated recent graduates more likely to desire and be a better fit for a job in a coal mine, aluminum smelter, or iPhone factory, or are better fits found at white collar, service-based internet or social media companies like Alibaba or Pinduoduo? These jobs are not available if the internet companies’ growth and innovation is stifled by the government.

The calendar – Earnings comparisons and the Communist Party Congress.

Starting in the third quarter of 2021, the effects of the government’s intervention and zero-tolerance COVID policy began to be seen in the earnings releases of Chinese technology companies. Assuming the worst of the government intervention is behind these companies by the second half of 2022, and COVID trails off in China, the year-over-year earnings comparisons should be a tailwind for Chinese technology companies. Additionally, the Communist Party Congress will hold their important meeting in the second half of 2022, most likely in October. History indicates a high probability that the government will stimulate the economy prior to the meeting. It is not in the government’s interest to have an economic slowdown ahead of the meeting.

Valuations – Record low absolute valuations meet record low relative valuations.

As we begin 2022, Chinese equities are inexpensive on both an absolute basis (relative to their own history) and relative to the U.S. equity market – S&P 500. They are trading at extremes that occur only a couple of times per decade. The probability is high that extremely negative future scenarios are factored into today’s valuations, and our reward-to-risk ratios are as compelling as any time in the past decade. We provide a few examples and commentary below:

First, we compare the S&P 500 to the China Index (GXC) on a valuation to future earnings basis. The S&P 500 presently trades at a 78% premium to China (P/E of U.S. 22 versus China 12). This is the highest premium since the GXC index was launched in 2007, and well above the 38% premium average.

Next, we show the Nasdaq-100 versus the China index (GXC). To own the Nasdaq-100, you are required to pay a 143% premium – another record.

Finally, here are three examples of some of the largest, highest quality Chinese equities’ historic price and valuation charts.

Alibaba (BABA) since 2014 IPO: Trades at a forward P/E of 12x with consensus earnings growth estimates at over 15% annualized through 2024, versus  consensus estimates for the S&P 500 of high-single digit growth.

Pinduoduo (PDD) since 2018 IPO: Trades at forward EV-to-sales of 2.6x versus a historic average of over 4x, while consensus estimates sales will compound at 25% per year through 2024.

Trip.com (TCOM) since 2004 IPO:  Earnings expected to inflect strongly in 2022-on. Estimated to earn $1.50-1.60 per share in 2023, meaning a P/E of only 15x for strong growth prospects.

Although we must always monitor the ongoing potential risks, we believe due to the combination of positively shifting monetary, fiscal, and social policy, along with 2022 economic stimulus, dissipating COVID headwinds, easier earnings comparisons, and extremely compelling valuation, high quality Chinese equities have a compelling reward-to-risk compared to many other investments as we begin 2022. Longer-term, we believe the Chinese government desires some version of “Made in China 2025,” one where large technology innovators grow, prosper, and most importantly employ the present generation of educated college graduates.

Justin McNichols, CFA

Justin is the Chief Investment Officer for OPCM, and has over 25 years of experience. Justin is a member of the OPCM Investment Management Team, and became a principal of the firm in 2000. Justin is a member of CFA Society San Francisco and CFA Institute. Justin received a Bachelor of Arts degree in Economics in three years and a M.B.A. in Finance from the University of California at Irvine. Additionally, he is a CFA Charterholder.
The opinions expressed herein are strictly those of Osborne Partners Capital Management, LLC ("OPCM") as of the date of the material and is subject to change. None of the data presented herein constitutes a recommendation or solicitation to invest in any particular investment strategy and should not be relied upon in making an investment decision. There is no guarantee that the investment strategies presented herein will work under all market conditions and investors should evaluate their ability to invest for the long-term. Each investor should select asset classes for investment based on his/her own goals, time horizon and risk tolerance. The information contained in this report is for informational purposes only and should not be deemed investment advice. Although information has been obtained from and is based upon sources OPCM believes to be reliable, we do not guarantee its accuracy and the information may be incomplete or condensed. Past performance is not indicative of future results. Inherent in any investment is the possibility of loss.