The latest pullback in China’s stock market raises a question: Is market volatility the old, new, or recurring normal? In the past few weeks, select industries and sectors have faced tighter regulatory policies, a development that has resulted in a sharp sell-off among certain sectors.
However, sector-focused regulatory and policy changes aren’t unusual for emerging markets such as China. In the past, risk-off and indiscriminate sell-offs have created mispricing opportunities for long-term investors. For example, in 2018, the video-gaming sector went through a major review cycle and regulators suspended approvals of gaming licenses.¹ Policy wise, the rollout of a centralized bulk procurement program for generic drugs in late 2018 also caused a correction in pharmaceutical stocks and in the wider healthcare sector. Below is a summary of are our summarized thoughts on the key recent events.
Recent events and their implications
In regard to the recent sell-off of after-school tutoring (AST) stocks in China,² the key implications of the new policy released on July 24 include:
- The mandatory conversion of K−12 (kindergarten through 12th grade) subject-tutoring firms to nonprofit institutions
- The prohibition of foreign capital investments in academic tutoring institutions—this includes VIE structures (variable interest entity, i.e., an offshore listing structure)
The scope of the official policy released was more significant than what we and the market had expected. With limited visibility on the future earnings profile in the space, the fundamentals of the AST sector had to be reassessed and expectations reset.
Given the subsequent sector-wide sell-off, it’s worth pointing out that the new policies are specific to tutorial schools, with the objective of protecting students’ well-being. However, tertiary and vocational training companies have been subjected indiscriminately to a sector-wide sell-off, which now present mispricing opportunities, in our view.
Indeed, tertiary education and vocational training are key areas where Chinese policymakers enhance the skillset of its labor force, alongside the country’s agenda to move up the value chain to innovation-led manufacturing and economic activities. China has set for itself the goal of achieving a 60% higher education enrollment rate by 2025 (from 51% in 2019 and 54% in 2020) and has been making progress.³ In 2021, the number of enrollments to Gaokao (university entry exam) reached a record high of 10.78 million, suggesting there’s a lot of unmet demand for higher education. Since 2018, regulations for commercial for-profit tertiary education has been revisited. The country’s policy on operations and merger and acquisition (M&A) activities for tertiary education (i.e., the Implementation Rules for the Law for Promoting Private Education) was released in May 2021 after nearly three years of consultation.⁴ The objective of the regulatory revamp was to promote the development—and increase the supply of—quality private tertiary education. As the regulatory revamp was just concluded, we don’t foresee further policy announcement on the tertiary education segment while regulated M&A activities have continued since May.
Property management services
A regulation notice was issued to property management services firms on July 23, triggering policy concerns among investors.⁵ The notice emphasized tightening control regarding inappropriate activities among firms within the space (for instance, failing to provide services in accordance with the standard contract and failing to disclose pricing rationale). While the controls on regulation notice aren’t new measures, the sector has been under pressure.
It’s important to remember that property management is one of the sectors that the government intends to support under its 14th five-year plan. As the industry consolidates, the sector is expected to grow and, in our view, quality sector leaders could gain market share at the expense of smaller and unlisted peers. Our positive view on the investment opportunities in this sector is further supported by the enlarged revenue pool from community value-added services. In addition, we’re of the view that the valuation of high-quality companies in the sector is now more attractive after the recent sharp correction.
Cybersecurity and antitrust review
The Cyberspace Administration of China (CAC) announced a cybersecurity inspection on certain ride-hailing platforms in early July soon after a few concerned companies listed their shares in the United States. In fact, the Measures for Cybersecurity Review, which aims to ensure the security of critical information infrastructure and safeguard national security, has already been in effect since June 2020. Platform operators are now expected to act as gatekeepers to protect personal information.
As data security issues and privacy-related regulations have emerged in China, the regulators are keeping a watchful eye on the collection, application, and security of data, following global regulatory initiatives to protect data privacy.⁶ Given its importance, we believe the current tightened regulatory environment on cybersecurity matters may stay for longer. We also expect more self-inspections, proactive rectifications, and internal controls from key players. The financial implications of these measures are yet to be defined.
Regarding antitrust investigations, we’re seeing some positive developments after a record fine was imposed on a leading player for monopolistic practices in April. Subsequently, most of the internet players summoned (33 in total) are reported to have signed anti-monopoly self-regulatory conventions in mid-July⁷ and pledged to gradually open up their platforms to promote fair competition.
While staying mindful of regulatory headwinds, we believe investors shouldn’t overlook potential policy tailwinds on sectors that are supported by government policies. For instance, the renewable energy sector can do well under China’s sustainability initiatives. Industrial automation, manufacturing upgrades, and ensuring semiconductor supply chain self-sufficiency are also on the top of the Chinese government’s agenda.
Renewable energy supply chain
We’re positive on China’s renewable energy sector—especially companies in the solar energy supply chain—where we see strong medium-term growth potential, driven by the government’s goal to reach carbon neutrality by 2060.⁸ In fact, solar power in China has achieved grid parity and could generate sustainable returns without government subsidies. We also like growth-oriented commodities, such as lithium, which are used for battery production. Battery and energy storage are important not only due to rising electric vehicle adoption in China, but they’re also critical in the context of wider renewable energy application.
For companies in the innovation space, we’ve been positive on biopharmaceuticals, particularly those engaged in oncology drug development. The investment team also sees attractive opportunities in contractual research organizations that enjoy solid demand from both local and global biotech companies. We’re positive on specialised medical services providers such as assisted fertility, which can benefit from China’s third-child policy push.
Despite policy headwinds, we believe the Chinese government’s goal is to keep its key sectors in check—not to curb their development—while encouraging innovation. Beyond the near-term volatility, we believe China’s fundamental, structural growth story remains intact. As China continues to elevate its economic composition, we believe policymakers will continue to push ahead with corporate governance and sector-specific policy reforms, ensuring that growth is managed and sustainable.
1 South China Morning Post, August 8, 2018. 2 The “Opinions on Reducing Homework Burden and After-school Tutoring Burden of Students in the Compulsory Education Stage” (aka Double Reduction policy) was officially released by the Chinese government on July 24, 2021. 3 Ministry of Education of the People’s Republic of China, March 31, 2021. 4 On May 14, 2021, the People’s Republic of China State Council announced the Implementation Rules for the Law for Promoting Private Education (Education Sector Implementation Rules). 5 Ministry of Housing and Urban-Rural Development of the People’s Republic of China, July 23, 2021. 6 The implementation of General Data Protection Regulation in Europe in 2018. 7 www.finance.sina.com.cn, July 14, 2021. 8 “China pledges to be “carbon neutral” by 2060,” Financial Times, September 23, 2020.
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