Chinese Stocks’ Crash Offers a Harsh Tutorial - Barron's

It took a while, but early last week investors recognized the increased risk embedded in Chinese stocks, after they tumbled in reaction to regulators’ latest focus: after-school tutoring companies. The losses slowed later in the week as Beijing tried to calm markets. But, as we’ve warned (“Some China Stocks Could Vanish From the U.S. What to Know,” July 16), the risks will remain elevated until more clarity on China’s regulatory push emerges.

The Invesco Golden Dragon exchange-traded fund (ticker: PGJ), which invests in U.S.-listed Chinese companies, is down 44% since mid-February as a flurry of regulatory moves target China’s most popular companies. The possible message: Foreigners who want to invest there must do so on Beijing’s terms and through China’s markets, writes Gavekal Research’s Louis-Vincent Gave, in a client note. At the same time, Chinese companies better mind the government’s demands or risk a smackdown—or worse—he adds.

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Money managers have offered an array of reasons for China’s moves, from reining in its internet titans, much as the U.S. and Europe are trying to do with theirs, to addressing growing social inequities and making pre-emptive moves aimed at protecting China from any U.S.-related regulatory measures.

Antimonopoly efforts and increased data scrutiny have sent newly public DiDi Global (DIDI) crashing and forced a reassessment of the growth prospects of online food-delivery giant Meituan (3690.Hong Kong), Alibaba Group Holding (BABA), and Tencent Holdings (700.Hong Kong). To placate Beijing, other companies have had to make changes, from fintech Ant Group’s overhauling its business model to Meituan’s paying higher wages and providing health insurance to workers.

Shares of Tal Education Group (TAL) and New Oriental Education & Technology Group (EDU) are down about 90% this year. They slid after China’s draconian crackdown on the tutoring sector upended their businesses and painfully illustrated how even fundamentally sound investments can quickly turn into losers when the state steps in.

The public rebuke of Alibaba and Ant co-founder Jack Ma and the scuttling of Ant’s initial public offering were stark reminders that the Communist Party looms large over China’s private sector and that Xi Jinping is tightening his control across all facets of the economy.

It has left investors unsettled. “What is alarming is the amount and pace at which these aggressive reforms are coming, irrespective of economic consequences,” says Rand Wrighton, head of international equities at value shop Barrow Hanley Global. “When, overnight, you wipe out $60 billion of capital [in education companies], that’s really bad. It’s starting to feel like the Chinese government is moving to insulate their capital markets from the U.S.”

Some Chinese internet companies’ valuations are so low that value managers are starting to kick the tires. Alibaba, for example, trades at 18 times next year’s expected earnings—a third of what Amazon.com (AMZN) fetches. But many money managers still see a six- to 12-month period of continued volatility, as investors increase their assumptions of political risk and gauge the policy shifts’ longer-term fallout.

“We have a toxic brew of an adverse turn of policy that overlaps with [the formerly] high valuations of growth champions,” says Wrighton, who cautions against evaluating Chinese internet companies in the same way that investors look at Amazon.com or Facebook (FB).“What they missed was the benefit of the rule of law. Amazon can withstand aggressive attacks by the government and be mostly fine. But if President Xi says to Alibaba, ‘This is the way it’s going to be,’ its answer is, ‘Yes, Sir.’ ”

Some of the fallout may accelerate U.S. scrutiny of Chinese companies. The Securities and Exchange Commission is already looking to implement recent legislation that paves the way for delisting Chinese companies that aren’t in compliance with U.S. auditing rules. And the controversial variable interest entity, or VIE, corporate structure that Chinese companies have long used to skirt foreign ownership rules has caught the renewed attention of U.S. lawmakers, some of whom suspect they could hide accounting problems.

China’s regulatory scrutiny could add fire to U.S. moves. “It could have been just a domestic regulatory story, but it intersects with class-action suits here and lawmakers saying the whole edifice of the VIE is potentially fraudulent,” says Jude Blanchette, who holds the Freeman Chair in China Studies at the Center for Strategic and International Studies. “Areas that were once compartmentalized as regulatory plays in Beijing are spilling over.”

The risks are especially large when investing in China through U.S.-listed stocks. Beijing has been urging more of its companies to return home, possibly to insulate its capital markets. As pressure mounts, some companies might want to go private. Money managers are monitoring China to see what it will do to encourage companies to delist in the U.S. and relist in their domestic market. Beijing could also try to limit new Chinese offerings in the U.S.

“The second Beijing makes one deleterious comment [about the VIE structure], it will set off a firestorm” in the U.S., Blanchette predicts.

The backdrop could worsen as 2022 approaches. It’s the year that Xi would normally step down, but that is unlikely. Human-rights issues could come to the fore as Beijing hosts the Winter Olympics—during which China might be extra sensitive to criticism and will want to appear as strong as possible.

For jittery investors, that wouldn’t be fun and games.

Write to Reshma Kapadia at reshma.kapadia@barrons.com

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