by Adam Wolfman – Research Analyst
As the prominence of leading technology and internet companies has grown over the past several years, so too have calls to increase their regulatory oversight. The most recent example has been a more assertive Chinese central government reexamining matters ranging from data security in foreign listings, labour laws governing contractors and the structure of education companies. Investors have taken notice, with the shares of several listed companies selling off in the wake of this increased scrutiny.
The volatility in the Chinese tech and internet sectors is understandable as an evolving regulatory regime broadens the range of economic outcomes for companies. Given the ability of the Chinese government to reshape the economy to meet its shifting priorities, investors should closely monitor how developments may impact industry structures, corporate governance and an individual company’s profit potential.
Importantly, we believe that although recent news flow has battered the stocks of several Chinese companies, the compelling investment theses underpinning the country’s tech and Internet space remain intact. The Chinese government, in our view, will continue to support the digitisation of the economy and it understands the role played by the private sector in achieving these ends. Similarly, we believe that the government will remain committed to sustaining access to foreign investment capital to help finance a host of transformative industries and companies.
A global phenomenon
Over the past decade, mobile technology, internet search, social media, e-commerce and cloud computing have redefined many aspects of the global economy. While much of this advancement has democratised business and placed a tremendous amount of information at consumers’ fingertips, the dominance of a handful of companies has rung the antitrust alarm bells as some regulators believe industry heavyweights have the potential to impede competition and inhibit consumer choice. A particularly sticky issue has been the control of user data as that is often the feedstock for gaining efficiencies in applications ranging from digital advertising to logistics and creditworthiness.
The first major salvo to rein in the purported power of ‘big tech’ was the European Union’s Global Data Protection Regulation (GDPR) in 2018. Not long after, two US regulatory bodies opened antitrust investigations of the country’s leading tech and internet companies. In this respect, recent developments in China can be viewed as that country addressing similar concerns. It’s likely more complicated, however, with other forces at play, including the gradual ‘decoupling’ of the global economy and the central government’s emphasis on the private sector working to achieve ends beneficial to society as a whole.
Implicit blessing
Not well understood by those who haven’t recently travelled to China is the level at which technology has permeated all aspects of daily life. This advancement has been driven by a highly innovative private sector seeking to meet the needs of a rapidly-expanding urban, consumer class. The share of e-commerce in retail trade is far higher than that of the US or Europe. The same holds true for digital transactions. Tencent, which started out as a social media company, has expanded aggressively into gaming and – more recently – fintech. Many of these digitally-forward companies have thrived due, in part, to a dearth of established offline competitors in their respective industries.
The ascendency of these Chinese tech darlings occurred with the implicit blessing of the central government. An innovative private sector was creating the productivity gains that would sustain economic growth and foster what officials long desired: homegrown, value-added companies that could become global leaders in their field.
Shifting landscape
We believe that the Chinese government still holds these priorities and continues to recognise the creative power of the private sector. But the global landscape has changed in recent years. As illustrated by the US-China trade war, these two economies have begun to decouple. More recently, the government’s tone has reminded the private sector that profitability should go hand-in-hand in achieving certain national priorities.
In this context, the recent regulatory push may be the result of a natural progression as the central government assesses geopolitical and domestic developments and recalibrates economic and social policy toward a more sustainable path for these industries and for the broader economy.
Remaining constructive – and patient
As seen in recent weeks, shifts in policy can have considerable market ramifications. Some stocks have been directly in the crosshairs of regulators. Ride-sharing giant Didi’s stock slid as the company undergoes a cybersecurity audit. Several education companies were informed they must switch to non-profit status – a move that wiped out a significant amount of market capitalisation. What remains to be seen is whether these – and other – steps are just to disincentivise Chinese tech companies from listing in the US, or are there further aims that could permanently limit minority shareholder returns. If there is an orderly transition toward Hong Kong exchange listings, Chinese companies can still access capital to finance growth and international investors will still be able to gain exposure to companies with innovative intellectual property and business models.
We believe that investors should exercise patience while awaiting greater transparency on future company earnings streams. In any country there is a degree of bumpiness as regulatory regimes are fine-tuned. Many companies caught up in the current headline risk continue to have what we view as advantaged business models and strong competitive positions. These industry leaders did not achieve this standing by accident and the seasoned management teams and ability to adapt that served them well in the past will likely continue to prove beneficial as they adapt to an evolving regulatory environment.
Consequently, price dislocations caused by these externalities may lead to attractive opportunities as the trajectories of these stocks eventually normalise. While such a path may result in elevated volatility over the near term, the magnitude of the opportunity, in our view, justifies the risk given the potential for multi-year compounding of earnings growth by China’s most innovative, well-positioned businesses.
