China has imposed stricter regulations on the education sector, extending the regulatory reach that had focused on e-commerce and internet companies as the authorities seek to prevent market abuse and improve oversight. The move caused education stocks to plunge and hit broader investor sentiment towards Chinese stocks (including large-cap internet companies).
The action bans after-school tutoring during weekends and holidays and reclassifies academic tutoring as ‘non-profit’. Companies will no longer be allowed to raise capital or accept foreign investment.
The move could spell the end of the sector. In our view, however, these measures are unlikely to work. Demand will likely encourage informal one-to-one classes, boost costs and lower quality.
Out to regulate, not destroy
More intense regulatory scrutiny is one of the reasons for the reversal, not only in education, but also in tech-related market capitalisations. On the upside, tighter rules on anti-trust, fintech and capital markets, data security and social equality should help contain systemic risk and prevent a disorderly expansion of capital.
Importantly, tech-related regulatory tightening is a global phenomenon. For example, in the US, leading social network and e-commerce platform companies face regulatory scrutiny as well.
Tech figures at both the macroeconomic and equity market levels.
- China’s digital economy accounts for about 40% of the country’s GDP (see exhibit 1).
- Its tech/internet sector represents about 40% of the weight of the MSCI China index.
As for policy, the government’s long-term objectives focus on technology, consumption and efficiency. Accordingly, we must conclude that Beijing does not intend to destroy these sectors since innovative companies will continue to be the growth drivers.
What is next?
Large internet companies could come under further scrutiny. The launch of the digital renminbi (e-CNY) may undermine leading e-payment players.
Tighter regulation of the property sectors will likely stay in place. High debt levels and increasingly expensive housing as well as the ever-rising cost of raising children could cause social unrest.
We believe that sectors closely related to gig workers (e.g. express delivery, food delivery, solo car and truck drivers) as well as companies that provide basic social infrastructure (e.g. healthcare internet platforms, consumable medical devices / equipment) are at risk.
What does it mean for investors?
Recent regulatory action has put the equity market on high alert and the latest news on the education sector could be seen as the last straw. Therecent correction could be an opportunity to take new positions and top up investments in high-conviction companies.
After the recent stricter regulations, we believe the leaders across many sectors could benefit in this transition as it will become harder for competitors to enter. Overall, we remain focused on three long-term structural trends in China.
- Technology & innovation: China’s economic transformation and tech advancement is supported by the size of the domestic market, higher research and development spending and a vast talent pool. The tech boom is also helping traditional industrial and manufacturing sectors. We see opportunities in the fields of capital goods, tech and industrial upgrading.
- Consumption: We see significant opportunities for leading companies in sectors such as insurance. This is thanks to rising household income, low household debt and more diversified consumer profiles. This will likely only accelerate in the next five to 10 years.
- Industry consolidation: Regulatory tightening, environmental cost pressures, higher financing costs and industrial upgrading are driving this. Companies will focus more on R&D, productivity and costs. Examples include the machinery and new economy sectors.
We believe these investment themes will stand the test of time regardless of Covid or Sino-US trade tensions. They guide our stock selection.
Beyond China, our Asian equities team focuses on these structural trends.
- Consumption: Turnaround & e-commerce
In consumer staples, we favour names offering margin turnaround potential (from the restructuring of distribution or brand repositioning). We also target companies with a history of double-digit sales growth in areas such as online travel, sports and electronic appliances.
- Technology: All about pricing power
Social distancing, work-from-home and 5G development have increased demand for IT equipment and products, while supply is tight. Pricing power has returned in integrated circuits foundries, display panels, dynamic random-access memory and passive components, benefiting companies in Taiwan and South Korea. We expect the semiconductor industry to grow at a low double-digit level in 2021.
- Financials: Towards further consolidation
In 2021, Asian banks will see their debt repayment burden rise as the policy of postponing loan repayments will likely expire, raising non-performing loan ratios. Better loan growth and stabilising margins should leave banks well positioned for an earnings recovery in 2021. We are seeing a unique situation wherein industry consolidation favours strong players.
A final word on regulation
What is clear to us – and unnerving for investors – is that compliance and regulatory costs will increase for e-commerce and internet names. However, these companies are at the forefront of technology adaptation, economic growth and, perhaps most importantly, the broadening of economic benefits to the masses. In our view, the regulators understand that it will be impossible for the state to further increase economic participation without these companies.
Companies that have been targeted have said they will do whatever the government asks. Fines have been accepted and one e-commerce giant promised to use all its profit this fiscal year to help merchants to grow their businesses on the platform. Another will invest in areas including basic science, education innovation, rural revitalisation, carbon neutrality, and public services.
We will watch and wait through the turbulence. Most of the news has already been priced in, although other companies in this field may still be subject to further action by regulators.
This is an extract.
Read the full note entitled CHINA REGULATION: FROM TECH TO EDUCATION – OUR VIEWS
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