Investing in China amid a changed regulatory paradigm
How might equity investors best capture the China opportunity? It’s a timely moment to reconsider the question. As China’s economy transitions from middle income to high income, we see enormous growth potential: Over the next 15 years, China is forecast to add more GDP than Japan, the eurozone, Brazil, Russia and India combined. However, the country’s recent wave of regulatory measures, slowing property market and accelerated drive for self-sufficiency present new risks and opportunities for international investors.
In this article, we:
- assess the attractiveness of Chinese consumer internet stocks amid a changed regulatory paradigm
- explore the risks and opportunities of investing in alignment with Beijing’s strategic policy objectives
- identify international companies poised to benefit from China’s growth despite Beijing’s drive toward self-sufficiency
These themes will be critical to a full understanding of the China opportunity on offer to global investors.
Chinese internet stocks and a new regulatory paradigm
Are Chinese consumer internet stocks still attractive? We note that the MSCI China Tech 100 Index is down over 45% from its peak in February 2021. The sell-off reflects various factors, most importantly China’s new regulatory paradigm.
In the past, internet giants such as Alibaba and Tencent, and China’s digital platform economy more broadly, were seen as engines of innovation, accelerating the government’s often-noted goal of shifting China from reliance on exports to a consumption-driven economy. These internet giants experienced many years of “light touch” regulation, with explicit support from Beijing. That environment changed a little more than a year ago. New laws and regulations addressed anti-competitive behavior, labor rights in the gig economy and data security—including suspending the app of ride-hailing company DiDi over allegations it had misused consumers’ personal data.
Amid increased scrutiny of the Chinese internet platforms, regulators are considering whether internet giants are now undermining growth and innovation in the economy. Some observers are asking whether companies like Alibaba and Tencent have moved into value extraction mode, refining their business models and harnessing the full power of acquired network effects—when a product or service’s value increases as the number of users increases.
Startups have few options but to make their products compatible with, and subordinate to, the major tech ecosystems, arguably diminishing research and development. At the same time, the internet giants are pulling talent and capital away from “hard tech” sectors such as semiconductors, areas of huge industrial-military strategic importance.
Critics may view regulatory pressure as hampering the optimal monetization of these companies’ respective platforms. But increased regulatory scrutiny of Chinese internet platforms also echoes the past (Exhibit 1). In the early 2000s, Chinese telecoms ranked as the economy’s high tech, high growth sector. They served a massive user base and accounted for 60% of the MSCI China Index. By 2011, bank stocks had taken their place to become the largest market sector, by market cap and index weighting. Both sectors faced much more focused regulation when they gained market dominance.
Regulatory scrutiny of top market sectors is not a new phenomenon
Exhibit 1: Ten largest Chinese companies by market cap (USD billion)
Regulators required that Chinese telecoms repeatedly cut tariffs even as they built a comprehensive mobile network. As a result, these companies became saddled with both the highest capex-to-sales ratios (20%–50%) and the lowest average revenue per unit (ARPU) within the global telecoms sector. Regulators have required banks in turn to bear high credit costs and build up substantial reserves as a bulwark to China’s highly leveraged economy—and this has in turn translated into lower returns on capital.
In China—and, indeed, in many developed economies—when a sector becomes the biggest, the most impactful and/or the most profitable, it is expected to assume more social responsibilities. This shift is underway today.
Alibaba has committed to investing all incremental profits in fiscal year 2022 in merchant support and “strategic areas and new businesses.” Tencent will invest a portion of incremental 2021 profits in business services, games, short video and a RMB 50 billion social value fund. Pinduoduo, the country’s largest agriculture-focused technology platform, announced a RMB 10 billion initiative to advance agritech. Certainly, regulation is influencing capital allocation into areas with uncertain payoffs.
A nuanced investment outlook
The investment implications of a more uncertain outlook for China’s internet sector are nuanced, particularly when valuation is factored in. Alibaba now trades on a 13x one-year forward price-earnings multiple, roughly a 75% discount to Amazon, the U.S. business it resembles most closely. In late 2018, when investors were most fearful of U.S. antitrust action against technology companies, Facebook traded as low as 14x forward P/E and Alphabet at 17x.1
But when it comes to the current outlook for Chinese internet stocks, investors must ask, What is the right multiple for a business whose management is not in control of its destiny and cannot allocate capital without the government’s implicit approval?
Over the long term, Chinese companies will face limits to how much value they can extract from their respective platforms and ecosystems. The network effects of a business will not be allowed to compound to such an extent that it develops a position of overwhelming market dominance. In other words, there is no “Chinese Uber,” “Chinese DoorDash” or “Chinese YouTube.” Their Chinese counterparts, DiDi, Meituan and Bilibili, operate in a very different political and regulatory environment than American companies.
In our view, if there is a natural ceiling to the value creation these companies can achieve (which seems plausible), it makes sense at this juncture to evaluate other domestic China opportunities. Some appear to be more aligned with China’s strategic government objectives.
Investing in a more policy-driven economy
Indeed, we find a wide range of opportunities for investing in alignment with Beijing’s strategic policy objectives. Those objectives include semiconductor self-sufficiency, carbon neutrality and greater industrial automation. Not only are companies in these areas likely to stay out of the regulatory crosshairs, they could actively benefit from government subsidies and tax breaks. However, as we will discuss, taking this more thematic approach introduces new risks around economics, duration and environmental, social and governance (ESG) factors, not to mention valuation.
Chinese electric vehicle manufacturers have emerged as credible competitors to Tesla.
Take the example of carbon neutrality and companies exposed to the renewables and electric vehicle (EV) supply chain in China. These stocks performed well over the past year, partly because they were not targets of regulation. But are these good businesses poised to generate attractive returns on capital as a complement to state-sponsored growth?
Our proprietary fundamental research finds that while some “green” stocks offer attractive expected returns, most are classified as “trading”2 and have red flags when it comes to ESG (Exhibit 2). They are mostly capital-intensive businesses operating in competitive but still early-stage industries—facing considerable risk that their technology becomes obsolete.
Some of China’s companies in the renewables and EV space face ESG red flags
Exhibit 2: Chinese “new energy” stocks through the lens of our proprietary fundamental research engine
We do see good potential within electric vehicle manufacturing and the EV supply chain, where China is emerging as a global leader. China has been by far the largest market for EVs over the last five years, accounting for over half of all sales volume globally. As a result, Chinese EV manufacturers, such as Xpeng and NIO, have leapfrogged automotive original equipment manufacturers (OEMs) elsewhere to emerge as credible competitors with Tesla.
In batteries, Chinese manufacturers such as CATL have assumed global technology leadership. CATL is typically the first to migrate to new cathode chemistries, giving the company the most diversified customer base among global suppliers. But this is no secret to investors: Based on consensus analysis estimates, CATL trades on 111x one-year forward P/E.
The outlook for enterprise software and cloud service providers
Some industries, such as enterprise software, offer more attractive economics and duration. Here, too, government policies should support the business. In enterprise software, a company with the right product can generate a steady stream of recurring revenues, “upselling” existing customers as new modules and functionalities are developed. Enterprise software is asset-light, high margin and very scalable. And the relatively low penetration of enterprise software in China creates an enormous market opportunity. By contrast, in the U.S. the penetration of enterprise software is roughly 15x greater.
The China opportunity should be largely captured by local players, such as Yonyou and Kingdee, given that the government is actively encouraging large enterprises that currently use Oracle and SAP to switch to a domestic alternative.
A similar dynamic is in play for local cloud service providers such as Alibaba, Tencent and Kingsoft. They are well positioned relative to Amazon Web Services (AWS), Azure and Google Cloud Platform (GCP) in the U.S. Even as regulators keep a close eye on the Chinese internet giants, those businesses are investing heavily in the digital infrastructure that will support important government objectives—notably, the smart grid and greater industrial automation. These commitments, coupled with Tencent’s and Alibaba’s healthy free cash flow generation and their stocks’ attractive valuation, have kept us invested in the companies after selling our positions in other Chinese internet businesses.
Investing in alignment with the government objectives can be challenging. Many of the companies set to benefit from policy imperatives do not clear the quality hurdles of our investment process for reasons of economics, duration and ESG. When we uncover selective opportunities in the enterprise software and EV supply chain, we need to ask if and when these companies might become so large and powerful that they will need to take on much greater social responsibilities.
The impact of China’s growing self-sufficiency on international companies
At this juncture, we shift our perspective and consider which international companies could continue to benefit from China’s likely still-substantial economic growth, in spite of the country’s drive toward self-sufficiency.
In semiconductors and luxury goods, we believe domestic Chinese industries will likely struggle to displace multinationals over a reasonable investment horizon.
The case of semiconductors
Paradoxically, perhaps, semiconductors is the area where China is making the biggest push for self-sufficiency. But in the end, we think Chinese companies will come up short. Given the current capabilities of Chinese businesses and U.S. efforts to restrict access to key technologies, we think non-Chinese companies will likely retain their edge in semiconductors over the medium term. As the Semiconductor Industry Association (SIA) highlights in a recent article, China lags significantly in advanced logic foundry production, exploratory data analysis (EDA) tools (think Cadence software), chip design intellectual property, semiconductor manufacturing equipment and semiconductor materials.3
To be sure, the government’s Made in China 2025 Plan, which has set a goal of 70% self-sufficiency by 2025, could boost the country’s semiconductor sector. Thus far, government support has come in the form of grants, equity investments, government procurement contracts and low interest rate loans, totaling over USD 100 billion.4 (For context, that is the equivalent of TSMC’s expanded capex guidance over the next three years.) Chinese companies have made significant progress in expanding production capacity of memory chips and less advanced logic chips. In addition, they are becoming more competitive in analog integrated circuit (IC) design for consumer and industrial use.
Silergy is a strong competitor, challenging the dominance of Texas Instruments and Analog Devices in power management ICs. However, companies like Silergy remain the exception. Observers note a vast gap between China’s domestic capability and that of, say, TSMC in leading-edge logic foundry process technology or ASML in high end lithography equipment. The gap almost certainly won’t be closed quickly.
In luxury goods, too, Chinese companies have so far failed to displace international brands. In 2021, Chinese consumers increasingly favored domestic labels in areas such as athleisure wear, fast fashion and electric vehicles. But luxury brands (think Louis Vuitton handbags and Speyside single-malt Scotch whiskies) appear as powerful as ever (Exhibit 3).
Most Searched Luxury Brands in China in 2021
- Louis Vuitton
These international brands have also been quietly committing more resources to China, running “local for local” supply chains. L’Oréal, the world’s largest beauty group, has been investing heavily in China over the last 20 years, most notably through its China Research & Innovation Center. At this facility, L’Oréal researches and develops products customized for the Chinese consumer. For example, the group has developed skin care products that protect against pollution, as well as new technology cosmetics geared more for global export (such as tackling aging skin and atopic dermatitis).
The increasing competitiveness of Chinese companies in sectors allied with the national drive for economic and industrial self-sufficiency presents risk and opportunity for investors. For some international companies, such as LVMH and ASML, the power of their brands or technologies acts as a nearly impenetrable competitive moat. For others, such as L’Oréal, decentralization and deep local integration have allowed their China businesses to thrive.
The recent regulatory scrutiny of Chinese internet companies is unlikely to subside. These companies operate under a different set of rules and obligations than their U.S. counterparts. This basic reality informs our forecasts for how much can realistically be achieved and the appropriate discount rates to apply to those companies’ cash flows. Even with risks fully reflected and current valuations looking very attractive, we should ask ourselves how much exposure we want to this cohort of stocks, in light of alternative opportunities.
We can—and do—invest in companies fully aligned with the government’s strategic objectives, such as semiconductor self-sufficiency, carbon neutrality and greater industrial automation. We find selective opportunities in the enterprise software sector and throughout the EV supply chain. Always, we bear in mind that market leaders might one day become so powerful that they become, in effect, targets for national service.
Finally, we continue to invest substantially in businesses headquartered outside China but thriving in the country, whose deep technology and brand equity give them a potent competitive advantage that should endure over any reasonable investment horizon.