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  1. Home
  2. / Investing
  3. / Stocks

Should U.S. Investors Ever Trust Chinese Stocks Again?

After being burned by Beijing, many U.S. investors are rightfully left wondering about their China-linked holdings.
By KEVIN CURRAN Jul 29, 2021 | 10:41 AM EDT
Stocks quotes in this article: BABA, BIDU, JD, TAL, DIDI, EDU, ARKK, TSLA, GDS

Despite fears about the Delta being at the forefront of U.S. investor attention as markets hit some turbulence into the close of July, the big trouble brewing for Chinese stocks is not something to be ignored.

In fact, in just a matter a few days, China's exchanges saw $2.6 billion in outflows while some of the nation's flagship stocks listed abroad, such as Alibaba (BABA) , Tencent (TCEHY), Baidu (BIDU) , and JD.com (JD)  , saw hits to their valuations in the hundreds of billions amid new regulatory rules laid out by Beijing. What's more, the education industry saw stocks like TAL Education Group (TAL) more than halved and the implosion of blockbuster IPOs like Ant Financial and Didi Global (DIDI) thus far this summer.

Amid the onslaught of bad news for investors emanating from the Chinese government, many U.S. investors are rightfully left wondering if they can really trust backing China-linked stocks any longer.

"While investors in Chinese equities are drawn to these firms by the incredible growth potential of the Chinese markets, these same investors must weigh that growth potential against potential government regulatory actions," Robert Johnson, Professor of Finance at the Heider College of Business commented. "With risks and potential risks increasing, investors are going to discount valuations."

Icarus Effect

Recent crackdowns by the Chinese government are notable not only in their relatively broad scope, but in their speed. The rapidity and severity of the regulatory changes was felt most strongly in the tutoring and education sector, where firms including New Oriental (EDU) saw their share prices cut by over 60% overnight.

"From the government point of view, education is their turf," Liqian Ren, Director of Modern Alpha at WisdomTree, said.

She explained that tutoring services in China had become increasingly expensive, forcing families to spend exorbitant amounts not only to ensure the success of their children in the test-based Chinese education system, but to keep up with their parental peers. Further, the increased need to spend highly on tutoring and education is exacerbating income inequality issues that persist in China. As such, state regulators were likely moved to act in the face of public outcry over education costs.

However, she added that the experience of these fast-rising education firms offers a broader lesson. That being that companies in China can quickly become victims of their own success.

"Extremely high profitability companies will become targets," Ren said. "Policy is shifting from favoring capital toward labor."

She cited the cybersecurity reviews of Tencent's Meituan and Didi as indicative of increased concern for Chinese labor and an effort to rein in its tech titans that now employ millions of Chinese citizens and wield significant power in Chinese society.

The logic of Ren's observations also appears to apply to governance concerns.

In much the same vein that the most profitable firms came under fire, the most successful CEOs in China have become targets of the party leadership and silenced. Jack Ma, the former celebrity-CEO of Alibaba is the best-known example, as his outspokenness on matters of party policy prompted his sudden disappearance from public life and even fueled rumors about his death.

By contrast, Tencent chairman and CEO Pony Ma has moved preemptively to accommodate party policy, moves the South China Morning Post recently suggested have kept the executive "in Beijing's good graces." His firm's preemptive move to stall WeChat registrations may well be seen as another sign of Ma's attentiveness to political risk.

In short, being a celebrity CEO is not the smartest move in the current Chinese environment. The best corporate governors will surely realize that and keep from flying too close to the sun.

The Crackdown in Context

To be sure, while the latest regulations came quite swiftly, they were not entirely unforeseeable.

Aside from the trade war waged under President Trump, China President Xi Jinping has not been shy about advancing the "Chinese Dream" of domestic Chinese leadership in numerous key industries and its general concerns on U.S. requirements for listing Chinese stocks.

"China's biggest concern which will impact foreign listings is geopolitical and the access the U.S. government has to the data collected by companies," Brian Brandsma, Deputy Portfolio Manager, Emerging Markets Equities at Vontobel Asset Management explained. "Going forward investors should expect that Chinese companies will be pressured to move to Hong Kong or a domestic exchange. A U.S. listing requires significant disclosure to the SEC and the Chinese government is no longer comfortable with this."

However, these restrictions are not entirely self-inflicted. Washington was already warning of its own designs on restricting U.S. listings for Chinese stocks for quite some time prior to Beijing's latest reforms. Such restrictions were due to rely, among other things, upon more stringent auditing and transparency requirements, a major concern in the wake of high profile frauds like Luckin Coffee (LKNCY).

As such, the telegraphing by Washington may have helped wean many investors off of the idea of chasing growth in U.S.-listed China stocks even before Beijing's latest move.

For example, Cathie Wood, the famed head of Ark Invest, has publicly thrown in the towel on China stocks. The flagship ARK Innovation ETF (ARKK) has cut holdings in China-based stocks from 8% in the first quarter to less than one-third of a percent amid the recent regulatory reform.

Containing a Contagion?

Yet, even for those not directly invested in Chinese stocks any longer, there is still significant reason to fear a potential wider contagion simply based upon widespread investment by institutions in China. Per a Reuters report, U.S. investors hold about $1 trillion of Chinese internet and tech stocks or hold U.S.-listed ADRs.

Perhaps the most high profile among the international investors intimately involved in China-based stocks is SoftBank's Vision Fund. Amid Beijing's crackdown on Didi, the Japanese giant reportedly fell $4 billion in the red on just that one investment. That loss is of course coupled with significant losses in its major holdings in Alibaba and other Chinese tech stalwarts that make up about 25% of its overall holdings.

If more significant restrictions and regulations are set to come as Chinese leadership continues to assert itself, the potential for firms with heavily concentrated holdings in China could be put at significant risk. Similarly, those U.S.-based firms staking their growth thesis on China, like Tesla (TSLA) , might be put into a tenuous position worthy of review for retail investors.

The essentially unlimited leeway offered to regulators by the CCP, which is increasingly in touch with its early communist roots, could allow the risk to run well beyond its present station, as significant as it already is.

Opportunity Amid the Unrest?

Still, there are many investors ready to disregard these risks, seeing the palpable fear about Chinese stocks as a buying opportunity.

"The Chinese government is showing that its actions are industry-specific and not broad, as has been the general perception especially in the gun-shy West," Randy Baron, Lead Portfolio Manager at Pinnacle Associated said. "This backdrop provides a wonderful opportunity for active stock pickers who know the businesses, and management, they own well."

As such, he said his firm is meaningfully increasing its exposure to China for the first time in three years, while being very selective about both the stocks and sectors that it targets. Baron cited GDS Holdings (GDS) as a particular long-term position that his firm is increasing exposure toward amid the downturn.

"In our opinion, it is the best data center business in the global industry," he commented. "They have wonderful management and are a contracted supplier to Alibaba and Tencent, meaning that if you think Chinese internet usage is going to grow, GDS is destined to grow exponentially with it."

For Baron, this opportunity outweighs the potential regulatory risk. For investors more generally, this is a question of trade-offs and risks they'll need to review very carefully.

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TAGS: IPOs | Regulation | Investing | Markets | Politics | Stocks | Trading | China

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