After a tumultuous period for U.S.-listed Chinese companies, many U.S. investors are finally concluding that Chinese companies aren’t worthy of a place in their portfolios.
It’s a truly shocking development. Several months ago, it was difficult to imagine what could derail the flow of foreign capital into Chinese stocks.
The catalyst was the Chinese Communist Party (CCP) and its regulatory regime. The beginning could be traced to last fall after regulators scuttled a planned IPO for Ant Group, the digital payments application, and attempted to rein in Alibaba founder Jack Ma. While Ant never IPO’ed and thus no retail investors were directly hurt, its early institutional investors (including U.S. investors such as Carlyle Group and Silver Lake Partners) are stuck without an exit as Ant has been forced to restructure and subject itself to an onerous financial regulatory framework—all of which could vastly diminish its value.
The CCP issued a series of rulings beginning in mid-July that education companies engaged in teaching or tutoring academics can’t be for-profit corporations, meaning they must become nonprofit groups. In addition, China banned IPO listings of and ownership in such education companies by foreign investors or other publicly traded entities. In one fell swoop, the CCP completely terminated the business model of an entire industry.
Among the three major Chinese tutoring companies listed in New York, their investors have lost a combined $18 billion in value since July 22. In other words, the three companies are worth 68 percent less today than their combined value as of a week earlier.
JP Morgan analysts were succinct while trying to strike an optimistic tone. “It’s unclear what level of restructuring the companies should undergo with a new regime and, in our view, this makes these stocks virtually uninvestable,” according to a Financial Times report.
“The announced guidelines present risks to the core food delivery business and could weigh on market sentiment,” Morgan Stanley analysts wrote in a note to clients on July 26.
In the same week, Beijing fined Tencent for anti-competitive behavior in how the entertainment giant structures its music rights, ordering Tencent to end exclusive rights deals with artists and record labels. The action sent Tencent shares crashing during the week.
These recent developments have finally awakened U.S. regulators.
This order by the SEC is too little, too late. Billions of dollars of value have been wiped from U.S. retail and institutional investors.
For years, we’ve argued in this publication that investing in Chinese stocks bears significant and unquantifiable risks. Besides macro, business, and market risks, there are also governance and political risks that could be knowable and unknowable. Investing in Chinese companies is different than investing in almost every other market.
Let’s examine a few fundamental reasons why someone picks a particular company to invest in. There are basic factors to consider—the company’s business model, its industry outlook, its barrier to entry, the quality of its management, its financial health, and macroeconomic trends impacting its business, sector, or the country it operates in. In addition, the investor must consider regulatory risks facing the company and its industry from the government within the jurisdictions of its operations.
It’s this latter risk that is considerably outsized with any Chinese company. The company must do the bidding of the CCP when the Party comes calling to hand over data or private information of its user base or even spy on its users. That’s certainly bad, but at least the risk can be understood and quantified.
But the CCP has demonstrated—in its recent crackdown of the tutoring sector—that it can bring down an entire industry and all companies within it in one order. We’re not arguing here that the CCP would deliberately kill successful companies or industries for no reason, but there’s certainly an impetus for the regime in Beijing to exert greater control over their direction and strategy. But from the perspective of foreign investors, the CCP’s whim is an existential risk that could strike any time without warning.
I’m not sure it’s a risk that can ever be adequately disclosed, quantified, or measured. At least not to a degree that should satisfy the SEC, whose role is to protect American investors. Outside of companies in obviously precarious industries such as gambling or vice, investors certainly didn’t consider a company’s viability in such a manner.
In hindsight, perhaps we may have all underestimated the existential risk that the CCP poses.
