8/17/2021
Over the last 20 years it has been easy to forget.
The publicly traded companies Alibaba, Bidu and Tencent, to name just a few, have become burgeoning investment stars. These goliaths have become the Chinese counterparts of Google, Amazon and Facebook, but with exclusive access to many Chinese consumers. Innovative, young and well capitalized, these companies have found eager shareholders globally. Market forces have blessed their stocks with high earnings multiples just like their American equivalents. The market capitalizations have been in the $100’s of billions for each company. But there is a key difference between the Chinese and American cohorts. That difference has been less visible, sometimes blurred out, and often forgotten altogether in recent decades. And the difference is more powerful than market forces.
The difference is China is communist.
China is ruled by a communist authoritarian party, the CCP, which is headed by Prime Minister Xi. The party’s mandate is to communism. The rule of law is subservient to the party. The party can change direction, without recourse from its citizenry, and crush or bolster any business at any time.
This is the stark environment that profit-seeking businesses in China find themselves. In the swift-moving crosscurrents of socialism and capitalism. Best laid plans aside, the CCP can choose who wins and loses. To stay afloat, you must comply, and penalties can be corporal even for civil infractions.
Most of the largest Chinese companies are majority state-owned. These include: Sinopec, China National Petroleum, China Construction Bank and China Life Insurance, among others. Some of these companies are publicly traded as well and have ownership structures with a minority of non-state shareholders. But there is no veil of who is in control. China Life Insurance, for example, is 70% owned by the State of China. So, it could never be bought or merge with another public company. The company is controlled by the state, despite the other shareholders.
If you have owned overseas listings of shares in privately owned, publicly traded Alibaba, Bidu, Tencent or JD.com, to name a few, you have experienced a pro-business attitude from the state of China over the last 20 years with lax regulations and few workers’ rights. It seemed as if the state had an interest in Chinese businesses being globally competitive, but not an interest to control them. To help but not control.
Over the last year, that laissez-faire approach has been pushed aside for a more proactive, interventionalist style. Prime minister Xi has asserted himself as an anticorruption warrior. But has been audacious in the scale and broad reach of what is now defined as corrupt. Some of the crackdowns are antimonopoly and antigraft, but others seem disjointed.
Recent examples:
Jack Ma, the founder of both Alibaba and Ant Financial, had given a speech deriding Chinese government regulators as having a ‘pawn-shop mentality’. He was subsequently pulled from officially running both companies. But the CCP wanted more vengeance. Ma had founded and endowed the Chinese equivalent of the Harvard Business School in 2015, Hupan University. Authorities have forced Ma to distance himself from the University which essentially will end the school.
Alibaba was forced to scuttle their Ant Financial IPO, which would have been the largest ever globally, after regulators blocked it. Ant was then forced to shed its crown jewel, the consumer lending business. Then Ant’s ownership was carved up to partners that the Chinese government selected, some with dubious histories. Including Huarong Asset Management, a corrupt “bad bank” on the verge of bankruptcy whose former CEO was executed for bribery earlier this year. Huarong was given a 4.99% stake in Ant Financial for no renumeration.
Alibaba was also fined $2.8 billion in April for “abusing its market dominance”. They had their web browser deleted from all app stores in March. The Alibaba browser was the second most popular on the market before it was deleted.
Meituan, China’s biggest food delivery platform, was hit with a $1 billion fine in relation to its market dominance.
Didi, China’s Uber and Lyft in one, had a sweeping government enforcement enacted against it two days after its IPO. The enforcement was over sharing customer data which crushed its $100 billion valuation by about a third.
Tencent was attacked by multiple state agencies in a coordinated campaign to reduce its market share. State media has labeled one of Tencent’s core businesses (video games) as “spiritual opium”. It is unclear if a ban or age limit or time limit is coming. Tencent’s WeChat messaging platform, with its 1.2 billion users, was forced to suspend new accounts for several weeks to comply with new regulations. And Tencent was fined and restricted from expanding a music streaming service under antimonopoly regulations.
Online Education and tutoring companies, several of which are listed on the NYSE, were blindsided in mid-July 2021 when they found out that new rules by the Ministry of Education barred them from being for-profit enterprises. A crushing blow to their industry and any shareholders holding their stock.
Cryptocurrency mining was banned in China in May 2021. It was then enforced in July 2021 when miners were cut off from essential services like clearing, settlement and account opening by Chinese banks. Although intimated in 2017 with the ban of crypto markets in China, the ban on mining has shocked the crypto markets as 40% of Bitcoin mining was done in mainland China.
In today’s global economy, investment capital flows like water to where it is treated best. If Prime minister Xi does not value foreign investors as partners, investment capital will flow out of China-based enterprises. And until the anticorruption crackdown is defined in scope and used less as a pretext to do the CCPs bidding, it is hard to recommend any new investments in China even at depressed prices. The Chinese government should be lauded for true anticorruption, a noble and needed cause. It’s the swift, draconian, and sometimes arbitrary enforcement that deflates nearly all investment thesis for owning Chinese equities.
It’s too late to sell many of the mega cap China plays, they have been roughly cut in half from their high-water marks. The outlook is still too murky to average down or add to positions. Perhaps the best move is to do nothing but wait until the climate has changed.
But the rug has been pulled out from under too many investors to forget who is in charge.
Justin Hudock
Starboard Wealth Management