By Geoffrey Smith
Investing.com -- Investors on China’s biggest tech stocks going to the moon have been seriously burned in the last couple of months.
Yet those fixated on the massive destruction of paper wealth (about $1 trillion, by most estimates) are probably missing the point. China’s Internet sector was riding for a fall, valuations had divorced themselves even further from reality than their U.S. equivalents, and the figures used to justify those valuations depended on a variety of sharp practices that any sensible government would have reined in long ago.
That the measures which triggered the fall were announced by the same government that is suppressing democracy in Hong Kong, running 're-education' camps in Xinjiang and trying to grab control of some of the world’s most important waterways does not, in itself, make them wrong.
Take for example the case of Meituan (OTC:MPNGY), a food delivery company backed by Tencent (HK:0700) Holdings (OTC:TCEHY), which shed some $60 billion of market value in a mere two days after the State Administration for Market Regulation published a warning to all such companies to ensure that they were paying at least the local minimum wage. $60 billion. For being reminded to obey the law, nothing more.
Or take the new draft regulations on competition, which end the pernicious habit – favored by integrated platform companies such as Alibaba (NYSE:BABA) and Tencent – of forcing merchants into contracts that deny them any choice over where else they can sell their goods, and whose payment systems they can use. This is Antitrust Regulation 101, and anyone with tears to spare can shed them for those denied growth opportunities over the last decade by the oligarchs of Chinese cyberspace.
The relative lack of Internet regulation (excepting free speech) allowed some powerful and ultimately misguided ideas about the sector’s earning power to take hold. These were amplified by the pandemic, which in China as elsewhere, accelerated the long-term trends to online activity of all sorts. As a result, the NASDAQ Golden Dragon China index, which includes most of the high-profile Chinese tech stocks listed in the U.S., more than doubled between the end of 2019 and the middle of 2021.
Even now, it’s still up from the start of 2020, albeit there are probably less traumatic ways of earning 10% over 18 months, even in today’s low-rate environment.
So take a step back and you see that all that has happened in the last two months has been to blow the froth off an overvalued, but still very valuable, sector. It follows from that – as Cathie Wood and a host of Chinese investors over the last 48 hours have already concluded – that the sector is now a much healthier place to invest in.
At least some in the sector agree. Xu Lei, who runs one of China’s biggest online marketplaces at JD (NASDAQ:JD).com, told analysts on a call on Monday that “We believe that the regulatory goals are conducive to JD’s long-term business growth. So far, our business maintains steady growth whilst committing to better compliance policies.”
For sure, the regulations are hitting some companies harder than others. There is no positive way (at least for shareholders) to spin a regulation that requires all online learning companies to become not-for-profit. And the announcement by Pinduoduo (NASDAQ:PDD) on Tuesday that it will dedicate its first 10 billion yuan in profit to Chinese farmers shows that companies are already adjusting their profitability to the threat of wealth redistribution raised by Xi at a government meeting last week.
More importantly, the biggest medium-term risk of all for investors in Chinese ADRs is still very much alive. The growing estrangement between the U.S. and China is already making it hard for Chinese companies to satisfy both countries’ exchange regulators. The risk is that one or other side will pressure at least some companies to give up their New York listing, a process that could leave U.S. investors sitting on sizable losses.
Much will depend on how far Beijing has to go in order to exert the degree of control over Internet entrepreneurs that official doctrine – expressed by Xi in two keynote speeches in 2019 and earlier this year – insists it must have.
One relatively recent, if rough, parallel is reassuring for Chinese ADR holders: when Vladimir Putin was asserting control over Russia's oligarchs in the early 2000s, it only took the example of Mikhail Khodorkovsky to convince the rest of the class that the smarter play was to submit politically and continue to milk their cash cows. The humbling of Alibaba’s Jack Ma, the alpha beast among the herd of Chinese Internet tycoons, is likely to have a similar effect. It’s a rare tycoon who chooses prison over profit on a point of pride or principle.