Investing in Chinese Stocks Is Not as Dramatic as You Think
Martin Lau, an FSSA fund manager well-versed in Asian equities, discusses China's sell-off and what increasing regulatory pressure means for investors.
This week on Morningstar's The Long View podcast, Martin Lau, manager of numerous FSSA funds--including FSSA Asian Equity Plus, FSSA China Growth, and FSSA Hong Kong Growth--discussed the recent sell-off of Chinese equities and heightened market intervention by Chinese regulators.
Examining what increasing regulatory pressure might mean for Chinese equities and new buying opportunities, Lau said that investors' view of Chinese stocks, particularly in the West, moves in cycles. He emphasized that, from his point of view, investing in China is neither as great nor as bad as investors often think.
Here are a few excerpts on investing in Chinese equities and navigating market regulations from Lau's conversation with Morningstar's Christine Benz and Jeff Ptak:
Benz: You're a seasoned investor in the Chinese stock market, which has sold off in recent months. In the past, you've said that the best time to invest in Chinese stocks is when everyone thinks they're bad. Is this one of those times? If so, how has your team responded?
Lau: It's a very timely question. First of all, I'm Chinese myself, and I was educated overseas. Half of my brain is kind of Chinese, and half of my brain is Western. And I find it quite interesting that a lot of the marginal investments in China are still driven by foreign capital. The Western world, typically, has some kind of imagination on China in three- to four-year periods. Just before two months ago, the consensus was pretty much positive across the board. If you asked people at the end of last year to list the best investment opportunities in the whole world, quite a few of them would say China--whether it be electric vehicles, Internet, delivery, Internet platforms, and son on. China was the best-performing market last year, so the consensus was "buy China."
If you count the Asia markets, China has actually been the best-performing market globally for two years in a row (up to the end of last year). The Western view on China typically moves in cycles; now, triggered by recent Internet and education industry regulations, this sentiment has taken a U-turn. Yesterday, we saw a huge sell-off by foreign investors, which I can understand.
From my point of view, China has never been as great as you think. It has also never been as bad as you think. Regulation has been perpetually present. From interactions the Chinese government has had with other countries in recent years, it shouldn't surprise you that the Chinese government is strong and has become stronger. China has always been top-down and interventionalist.
People are suddenly waking up to the fact that there is actually top-down policy risk. From our perspective, though, the fact that markets are aware of risks is positive.
The same thing applies to the inflation interest rate. You might think we never know whether an interest rate is going to rise and how much and when. But we often view concern about inflation, interest rates, and top-down regulation as a good thing. This is because, at the end of the day, the best time to buy a market is when the risk premium is high. Compared with one or two months ago, I do think now is a better time to buy China. Whether you should buy China instead of other things, however, is another question.
I think this is actually the time to test our confidence--or investors' confidence--in the stocks we actually own. We are a strong believer that share prices follow earnings. So, if you tell me today that you are very confident about a company, whereby the earnings would be 50% higher in five years' time compared with today, I would say the return from that stock would have very little to do with whether China is tackling one or two industries today.
So, at the end, you need to believe that share prices follow earnings. We are bottom-up investors who try to find companies where this is the case.
Ptak: Have any of your assumptions about the state of public/private partnerships in China changed in ways that have impacted stock-picking or portfolio structuring? You've been relatively sanguine, even earlier in the year when regulators were cracking down on some of the monopolistic practices in the e-commerce space. You pointed out it was already quite competitive. If it grows--and even if growth slows--it could spell for larger profits for the players in that space. Do you still feel the same way, or have recent events changed your thinking?
Lau: Yes. Our views on this public-private partnership--or state-owned companies versus private companies--has changed over the years. When I first started looking at China, it was basically all state-owned companies. So, everything was controlled by the state; almost all the listed companies were Chinese companies. And then the problem was, of course, the misalignment of interest, the lack of incentive, and often state-owned companies are typically more focused on expansion or revenue, rather than return in profitability or shareholders. And then the private companies started to emerge--the likes of Alibaba (BABA), Tencent (TCEHY), and others. Typically, because it's their own business, they are entrepreneurial, they are more driven, they are more focused on return and cash flow. Of course, from time to time, they took too much risk. And, of course, from time to time, there was also government intervention.
If you look back, even before the Internet, it was actually quite common that certain businessmen got arrested and subsequently the business failed. For many years, we were actually looking for entrepreneurs and strong, private companies with the right culture; they want to achieve something and do something in China. If you look at Tencent--of which we've been a shareholder since 2005--it's been a phenomenal achievement. We saw them grow from a small company into a gigantic one. So, the process has been extremely rewarding.
However, over the past two years, we're starting to see some changes. And these changes began before the recent scare over the intervention. What we've seen is that companies have become very big. If you look at DiDi (DIDI), they dominate ride-sharing; you look at e-commerce, Alibaba dominated and still dominates the e-commerce space with 70% plus market share.
First of all, there's a question about dominance, even without the intervention from the government: where is the extra room for growth? We have been looking at the results from Apple (AAPL), Google (GOOGL), and so on. They all reported pretty decent results. However, if you look at the Chinese companies--even before the Chinese government intervention recently--they are starting to see increasing pressure because there are a lot of big companies, and they all compete with each other. China already has more than 1 billion e-commerce or Internet users. Basically, China just has 1.3 billion people. So, you're really competing for the marginal extra new users, and it becomes very competitive.
With intervention, we've seen that it is cyclical. For many years, people would say that the Chinese government is capitalist, even though they call themselves socialist or communist. And they are very pro-business. When Deng Xiaoping, the first leader who opened up China said, we need to let a small group of people become wealthy first, and then that really triggered all the reforms. But then in recent years, obviously, it became more socialist. I will say this is actually not just a China phenomenon, it is probably a global phenomenon as well. The government started to question more about the rights of employees, the rights of workers, the rights of small businesses. And therefore, you see all these kinds of measures, which are targeted at the more monopolistic companies.
I would say this is actually a quite a big change, and this is going to stay for quite some time. When I say this is cyclical, for all governments, economies, and things like that, so these things come in cycles. So, when we started off, you probably have very little regulation, and certain companies became very, very successful. And then whenever the companies become big, of course, the politicians or the government would start to concern, and this is a global phenomenon also. And they would start to regulate, intervene, and so on. When they overdo it--there's a case that they have already overdone it a bit--then they will observe the market. They observe the capital being raised, and subsequently capital being raised is still important for the economy. And then they would also adjust.
So, I think the regulators are also learning along with investors as to how to adjust for this new kind of thing that some of these companies have become so big. So, my view on this one is, it's an ongoing thing. The education regulation was a surprise, even to us. It has been very, very strict. I guess that's also a wake-up call for people to look at China. There are certain risks that are attached to China, because China is a very top-down country still. I think investors will adjust and just move forward.
Maya Sibul does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.