China’s crackdown is a stark reminder that investing is complex. It’s not just about supply and demand, buying low and selling high, or finding high quality businesses for low prices. Ultimately, governments have the power to impose, impose fines, seize property, nationalize and imprison. At the same time, their power to spend and subsidize also creates opportunities.
The truth is, investors have always lived with this uncertainty and many will have been burned by a sudden change in policy at some point in their life as an investor – perhaps more often in emerging markets, but also developed ones.
This does not mean that a market cannot be invested, but it does mean that we must be prepared for future policy changes when estimating cash flow, valuing assets and applying. a safety margin. This time, the impact was particularly significant because, first, the businesses and industries most affected were not heavily regulated and, second, the policy changes were abrupt, significant and far-reaching.
So who exactly is targeted? So far, we have witnessed scrutiny of independent, large and profitable companies or those whose mission is perceived to be at odds with the societal priorities of the government, such as encouraging population growth.
There was also more emphasis on the structures used by foreign investors to gain exposure. Valid concerns have been raised about weaker shareholder rights and protections compared to typical common stocks. As a result, stock prices fell sharply for large, widely held companies including Tencent, Baidu, and Alibaba, despite their dominant market positions and strategic advantages over their hard-to-replicate competitors.
The big question is: what should investors do in response to bad news? This is a rather delicate point to answer, because it depends on the starting position of the investor, his risk tolerance and his objectives. If, however, the goal is to create or benefit from wealth, then this problem is best viewed from a multi-asset perspective.
Taking this prism, it raises many questions about relativity – for example, do these developments mean that an allocation to China is less or more attractive compared to other equity markets? Does it have the characteristics of a great buying opportunity or a value trap? Would a change in exposure improve the total portfolio result or lead to undesirable risks?
The crackdown in China has some characteristics – but not enough – to make it a great opportunity to go against the grain. Our experience of previous âoutcastsâ – where we have achieved high returns for clients in our own multi-asset portfolios – includes Russia, Korea and energy stocks. Common characteristics of these contrarian opportunities included: 1) terrible economic or corporate news; 2) sustained sale; 3) falls of more than 50% in the price of the shares; 4) extremely low prices relative to fundamentals, using historical scenarios and a range of potential scenarios; and 5) the concern, contempt and pessimism of the investment community.
China meets conditions 1 and 2. It is also just below 3, with the share price falling by around 40% for the Hang Seng Tech index (through September 13). However, it fails at point 4 – despite several companies sitting at multi-year lows from current fundamentals. As for point 5, recent investor surveys show a dramatic drop in support for global emerging markets, of which China remains the dominant part, but there are no clear signs of hopelessness with notable investors and institutions remaining very strong. active.
As for the downsides, a value trap checklist should include technological obsolescence, changes in government policy, and excessive leverage at the industry or country level. Despite some concerns about Chinese debt levels, for the most impacted companies, we can probably rule out the first and third, given that these companies are in the lead or benefit from technological change and are not heavily indebted.
The other side of commerce
It’s always worth thinking about who is on the other side of any trade. At this point, China’s most vocal critics have warned of further adverse policy changes affecting profits. This is a legitimate concern and should be part of any investor’s scenario analysis. China does not have the democratic processes that slow down big political changes or make them more transparent – although this is not new information.
Additionally, many of the government’s underlying concerns, such as the power of big tech, are common in other countries where regulatory and tax changes are also underway. As we examine the range of potential scenarios, our valuation analysis suggests that this is not a value trap – unless your central case is a throwback to the economic policy era of the economy. Chairman Mao.
So are Chinese stocks a worthwhile addition to investment portfolios? From a long-term valuation perspective, China now offers better absolute and relative value than before the sell-off, even taking into account the impact of announcements and potential additional shocks. As such, the case for exposure to China is strengthening, albeit from a weak base. Our own portfolios reflect this assessment: having had less than usual in China, we supplemented exposure from low levels in more growth oriented multi-asset portfolios.
Mike Coop is Chief Investment Officer, EMEA at Morningstar Investment Management Europe