China’s tech crackdown – Q&A with 4Factor’s Investment Director

1. Why is China cracking down on big tech?

China’s internet sector has grown at astonishing speed, with its ‘national champions’ scaling rapidly to compete with the world’s leading technology companies. The new wave of anti-trust regulations and recent developments in the Chinese regulatory environment have hit the sector hard. Chinese technology stocks (US-listed ADRs and Hong Kong-listed stocks) have fallen more than 33% from their February 2021 highs, losing nearly US$ 1 trillion of listed market cap. This stands in sharp contrast to US technology and internet companies, which have rallied to all-time highs this year.

The Chinese government views the largest internet platform companies through the lenses of monopoly power, financial stability risks and national security threats on personal data - areas which arguably can and should be better regulated.

While greater scrutiny of internet giants is a global phenomenon, in China’s context the government sees these interventions as overdue regulatory enhancements after years of blistering growth by internet majors. China’s anti-trust policy appears to upgrade the regulatory framework with the aim of ensuring the country’s internet giants neither grow at the expense of society overall nor control all data flow. China’s fast-growing internet companies will need to adapt and re-adjust business models to better align with the government’s overarching goals.

After the massive overhaul of Ant Group to contain systemic risks in the Fintech sector and the anti-trust fine imposed on Alibaba*, China’s regulatory focus is shifting to other companies in the sector. Tencent’s* M&A deals are attracting regulatory scrutiny, and regulators appear poised to block the long-awaited merger between the two leading video gaming streaming sites in China – Tencent Holding’s DouYu International and Huya. Meanwhile, investigations continue to expand in scope, as seen with the recent investigation of cyber security violations by Didi Chuxing and Full Truck Alliance, shortly after their IPOs. Now, more than 30 companies are being investigated by the State Administration for Market Regulation (SAMR).

2. Tighter VIE and overseas listing regulations - what does this mean for investors?

Didi Chuxing, the Uber of China, listed in the US on the 30 June 2021. Since then the stock has cratered as the market was surprised by unanticipated regulatory action by the Chinese government. The Chinese cyber security regulator announced on 2 July that it had begun an investigation of Didi, and two days later ordered that the company’s app be removed from smartphone app stores (although existing users can still use it as normal). Another recent IPO – Full Truck Alliance (a digital freight and logistics platform) – seems to have faltered for the same reason.

The unusual velocity of regulatory oversight against Didi, together with two similar probes, appears to be driven by increasing sensitivity on the Chinese side over data security. As part of China’s comprehensive regulatory revamp of the sector, Chinese companies are now facing controls on all US listings. China is moving to change its laws to block a VIE (variable interest entity) listing overseas without prior approval. Currently, if a company is registered in, say, the Cayman Islands there is no formal requirement to obtain such approval.

These rules requiring an approval process in China have put all upcoming ADR listings on notice. Six of the global top ten unicorns by market cap (including Bytedance) are Chinese. They will effectively see their ADR listing window closed off.

Even as the Chinese authorities revise the rules that let Chinese VIEs list overseas without approvals, the leadership appears to have side stepped the question of the VIE structure itself, which keeps it in the grey zone – where it has always been. We do not expect a regulatory shock on VIEs, and the new approval process may even give a regulatory nod to VIEs listed in Hong Kong, Shanghai and any pre-approved names in the US.

However, we believe the ADR market will continue to shrink over time as Hong Kong or China’s domestic A-share markets become the venue of choice for Chinese tech listings going forward. There is now an almost uncanny alignment between the US and China as neither of them are keen on Chinese companies listing in the US. Increasing scrutiny around data from China and heightened compliance requirements from the US Securities and Exchange Commission (SEC) for primary US listings by Chinese companies could lead to more Chinese companies migrating back home – a process that is already underway. Financial intermediaries (like Hong Kong Exchange*) are clear beneficiaries of this trend.

3. How are we navigating elevated policy risk?

We have not invested in either Didi Chuxing or Full Truck Alliance. Several other Chinese companies have also listed in the US this year; we have not invested in any of them. So, there has been no direct impact on our portfolios from this situation.

Our VIE holdings (Alibaba, Tencent, Meituan) are all listed in Hong Kong and we have been shifting our exposure from the US to Hong Kong since Q4 last year. Thus we are, to a great extent, insulated from the developments outlined above. We have one small holding, Tencent Music, in the US ADR market, which has suffered in the recent sell off. The company is planning to list in Hong Kong.

We are underweight the communication services and online retailing component of the consumer discretionary sector, as fierce competition in e-commerce and regulatory headwinds in the wider sector have hit earnings momentum. From a 4Factor perspective, our ‘Earnings’ Factor steer in China internet is sharply negative and at 5-year lows (see Figure 1). Consensus earnings for internet companies have been revised down by more than 20% over the year to date, compared to other companies in the MSCI China Index for which earnings have been revised up 5%.

The sector has de-rated significantly, but despite this value, we think an underweight position in the sector is warranted until regulatory clarity emerges. We believe for the sector to see a re-rating of price-to-earnings multiples China’s internet companies need to reach a new equilibrium, which will involve compromises with the regulator. We are in the early stages of this; previous waves of regulation have lasted about a year. A key consideration for our analysts is determining to what extent this impacts the medium-term profitability and growth prospects of the major companies and how smaller, more nimble players may be better able to compete against the majors. Despite increasing domestic policy uncertainty and the difficulty in predicting how this evolves, we would note that China’s leadership relies on a vibrant tech sector. Domestic demand, digitalisation, and upgrading its economy are critical planks in Beijing’s thinking. This underpins our view that a stable equilibrium will eventually be found between the regulator and the internet giants.

The EV and renewables supply chain, which enjoys policy backing from the Chinese government, is benefitting from a major capex cycle after China’s carbon neutrality announcement. This is an area where we are finding interesting opportunities and allocating capital. More generally, we believe local presence in China is critical to navigate the headline policy risk, and as the domestic A-share market is more insular and domestically driven, it provides a good hedge against these risks in offshore China.

Figure 1. Overweight/underweight internet (retail) earnings steer

Source: Ninety One. As at 30 June 2021. For illustrative purposes only. This chart shows the earnings steer of the top quartile of 4Factor scores relative to the 4Factor universe. An indication of where our proprietary 4Factor screen is identifying ‘good ideas’ – relative to the average or expected output for internet (retail) sector. For further information on investment process, please see the Important Information section

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* These stocks are held in 4Factor portfolios.

No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided.
This is not a buy, sell or hold recommendation for any particular security. For further information on specific portfolio names, please see the Important information section.