Not so much bull in the China equity shop!
Global investors are losing their appetite for China equities following growing interference by China’s government in business and financial activities. Over the past year or two, China has stepped in to delay and influence the listing of billionaire Jack Ma’s Ant Group; issued a range of anti-trust fines, including a whopping US$2.8 billion fine to Alibaba; and instructed Uber-equivalent, Didi, to remove 25 of its apps from online app stores. Clearly, the bull is no longer rampant in the China equity shop!
The pros and cons of tech stocks
“Tougher enforcement of China’s rules and regulations around the growing technology sector have contributed to increased risk and higher volatility in China’s financial markets,” said Matthew Spencer, Head of the Investment Counsellor Group, at Orbis Investments, during a November 2021 update. This volatility has had both positive and negative effects on the returns generated in the Orbis Global Equity Fund, which has had as much as 20% exposure to Chinese technology stocks at times.
In the three years to end-January 2020, the Orbis Global Equity Strategy delivered 7.4% per annum in absolute GBP returns, net of expenses and fees; but still lagged the MSCI World Index. This lag, it turns out, was due to the asset manager’s preference for value-focused, bottom-up stock picking coupled with its genuine concern about the valuations of US-listed growth stocks over that period. “Going into pandemic, we felt that there were parts of the market where share prices had become untethered from fundamentals, especially in the US, and especially in big tech,” said Spencer. “We favoured value stocks and companies in emerging markets, which [ended up] doing okay, but not as well as the former”.
Even before the Chinese government played its hand, asset managers were struggling to optimally balance portfolios for the economic and social fallout associated with the Covid-19 shock. The 2020/21 pandemic caused an overnight collapse on global financial markets, with the MSCI World Index falling 26% between 12 February and 26 March 2020, before staging a rapid recovery. “It was an unequal drawdown, because value shares got beaten up a lot more than growth shares,” said Spencer. “And when I saw that, I remember giving out an audible groan, because I knew that we were overweight value and I felt that it would be painful”. Yes, dear reader, asset managers feel the pain of swift market corrections too! Orbis was somewhat insulated thanks to its higher weighting to China-listed internet giants, which proved resilient through the pandemic crisis.
Active management proving its worth, sometimes…
The value of an active fund manager exhibits in its ability to reposition and resize portfolio holdings to reflect changing market conditions. Following the pandemic market collapse, Orbis reduced its Chinese tech holdings in favour of oversold companies with stable fundamentals and companies that were cyclical in nature. “What you find during a crisis is that cyclical shares all come down to ground zero, and if you have the capabilities to sift through the opportunity set for those cyclicals that will prove more resilient, you can do very well,” Spencer said. The market bounced back from its 23 March 2020 lows, taking the Orbis Equity Global Fund up 63% compared to the MSCI World Index’s 53% correction by 31 May 2021. Investors enjoyed a positive experience, measured on both an absolute and relative return basis for the 14-month period.
Unfortunately, things took a turn for the worse between June and September 2021, as the delta variant of Covid-19 raised its head, causing value stocks to take a fresh pounding. “The part of the portfolio that normally held up well was the Chinese internet stocks; but this time around, not only did they not hold up that well, but they turned around and kicked us between the legs,” noted Spencer, who added that five of the fund’s eight portfolio laggards were in this sector. Further pressure was introduced via interference by China’s regulators in the online education sector, causing a blanket sell-off of tech shares and a 30% ‘hit’ to Orbis’ China tech portfolio. The result: Orbis Global Equity Fund was flat June to end-September 2021 compared to a 7% rise on the MSCI World Index.
Stanley Lu, emerging market researcher at Orbis Investments Hong Kong, singled out two events to explain the China experience. The first was that China’s regulators had upped their game insofar enforcement of anti-trust laws that had been in place since 2007. And the second centred on the behaviour by business leaders who were increasingly challenging government’s authority. “The Covid-led acceleration of digitization showed the true dominance of internet platforms, and government felt compelled to introduce certain rules and regulations to address these issues,” he said. Government set out to punish monopolistic business behaviours; prevent the exploitation of small businesses or consumers; and clamp down on anyone who challenges its authority.
What the heck happened in China?
Spencer put his China expert on the spot, asking: “Is there any framework you can put together to make sure that you marry up our bottom-up stock-picking methodology with an environment where the macro factors must be considered?” Lu conceded that while the bottom-up research approach was a key strength, it would be irresponsible to ignore macroeconomic developments, especially in emerging markets. The first step was to identify the long-term political objectives in a region, before considering what regulators might do to steer the economy along that path.
Lu offered up examples of external and internal challenges that China’s government would have to respond to in coming months. “An obvious external challenge is the deteriorating relationship with the West and the rest of the world; this explains the Chinese government’s desire to ensure self-sufficiency,” he said. In this context, the focus remains on basic science, decarbonisation, infrastructure and technology. Internal challenges include deteriorating demographics, inequality and political stability, among a long list of other issues. A final observation was that China’s single party political system, together with the highly concentrated power within the party, allowed the country to implement policies at a speed much faster than in Western democracies.
Should investors be concerned about remaining at weight or overweight in China equites? “The regulatory environment may look scary from the outside in; but we are mindful of the risks and we constantly evaluate any risk reward trade-offs in addition to our bottom-up fundamental research to assess market prices versus intrinsic value,” concluded Lu. “We will continue to pick stocks in China, and we will continue to evaluate these against the potential risks and opportunities”. The firm still holds big positions in Tencent, which is good news for South African investors, given our exchange’s heavy reliance on the tech giant through Naspers / Prosus.
Writer’s thoughts:
One cannot blame investors for being wary of China given recent experiences. The question is whether China’s determined and purposeful meddling in financial markets is better or worse than the ongoing policy uncertainty bungle that clouds South Africa. History proves that China’s policies work out over the long-term! How do you advise clients who want to invest part of their discretionary portfolios in riskier markets such as China? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected]
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