Chinese Stocks Are Starting to Look Like Bargains

Investing in China is more difficult than normal these days, prompting some to question if it’s worth the effort. And it’s not going to get much simpler in the immediate future, but volatility in the coming months may present opportunities for long-term investors.

Chinese officials have been pursuing the country’s largest and most popularly owned internet businesses since canceling Ant Group’s expected public offering last autumn. Beijing struck again on July 2, starting a cybersecurity assessment of DiDi Global (ticker: DIDI) and ordering the company’s app to be removed from app stores, as it tightened data security and standards for businesses listed overseas.

The decision, which came just days after raised $4.4 billion in the year’s largest IPO, caused the stock to plummet by a fifth of its value on July 6 and shook other Chinese internet stocks. Investors are bracing for further scrutiny of internet companies’ data practices and other regulatory actions, as the KraneShares CSI China Internet exchange-traded fund (KWEB) has dropped 15% since June 30.

Gavekal Research’s head of research, Arthur Kroeber, said, “We now know this is a regulatory quagmire, and those that expose themselves to the industry are taking on a lot of volatility.” “If you have a long-term view, this will be one of the next decade’s growth stories, and you must ride it out. If you’re looking for something more immediate, you might claim it’s too difficult and return in a year when things have settled down.”

The flurry of regulatory actions has produced the kind of ambiguity that attracts bargain hunters. Technology behemoths like Alibaba Group Holding (BABA), whose stock has dropped 11% this year, are catching value managers’ attention. However, care is advised, particularly for investors in shares of Chinese businesses listed on the New York Stock Exchange. Regulatory pressures may persist. Kenneth Zhou, a lawyer at Beijing law firm WilmerHale, adds, “It’s probably just the beginning of the enforcement activities.”

China’s regulatory push has been portrayed by fund managers as an attempt to acquire greater control and put in place safeguards for fast-growing digital businesses and internet behemoths. It’s also a means for Beijing to cope with rising US-China tensions, which are being exacerbated by new legislation in Washington that sets the stage for Chinese firms to be delisted if they don’t provide more auditing disclosures within three years.

One source of concern for Chinese officials is the vast amounts of data acquired by Chinese internet companies listed in the United States, which might pose a national security risk.

In a recent research note, Rory Green, director of China and Asia research at TS Lombard, wrote, “Data control is turning up to be a major internal and geopolitical problem, with direct equity market ramifications for businesses operating on both sides of the Pacific.”

Beijing is attempting to establish greater control over Chinese businesses, even those that are publicly traded. Many of China’s biggest digital companies, including Alibaba, Tencent Holdings (700.Hong Kong), and JD.com (JD), are registered in the Cayman Islands and employ a variable interest entity (VIE) structure to avoid Chinese foreign ownership limitations. The complicated structure, which is usually overlooked by investors, is a gray area since it prevents foreigners from owning a share in a Chinese firm. Instead, they must rely on China to keep promises made to the firm.

China has mostly ignored the extralegal system for decades, but it is suddenly paying more attention. According to Bloomberg News, Beijing is considering requiring firms that utilize this structure to get clearance from the Chinese government before listing overseas. Companies that have already been listed may need to get clearance for any secondary offers.

Analysts and money managers predict that China will not be able to reverse the VIEs, which are utilized by the country’s largest and most successful firms and would take decades to dismantle. Many others are also doubtful that the US would follow through on its threat to delist the country.

VIE inspection, on the other hand, may be used by Beijing to establish greater control over firms and to fight back against US authorities’ demands for more transparency. Indirectly, the investigation would likely reinforce Beijing’s attempts to get local businesses to return home, a push that has already resulted in secondary listings in Hong Kong for Alibaba, Yum China Holdings (YUMC), and JD.com.

Analysts predict that increased scrutiny will limit, if not halt, the number of Chinese firms going public in the United States in the near future. It may also reduce the number of U.S.-listed Chinese firms that appeal to do-it-yourself retail investors, which now stands at over 240 with a combined market value of over $2 trillion. According to Louis Lau, manager of the Brandes Emerging Markets Value fund, any of these that are unable to achieve secondary listings in Hong Kong or China may go private.

Stocks listed in the United States may see more volatility as a result. Whenever feasible, fund managers and institutional investors, including Lau, have gravitated toward stocks listed in Hong Kong or mainland China. Mutual or exchange-traded funds are the greatest method for ordinary investors to have access to these international listings, as well as the more locally oriented equities that certain fund managers choose.

Money managers are better equipped to deal with the logistical challenges posed by US-China tensions, such as the repercussions from a recent executive order prohibiting US investment in firms with connections to China’s military complex, according to Washington. The S&P Dow Jones Indices and the FTSE Russell agreed earlier this month to delist more than 20 Shanghai and Shenzhen-listed companies.

Other firms might be blacklisted, resulting in similar consequences, according to Reuters, which reported on July 9 that the Biden administration is contemplating adding more Chinese entities to the prohibited list due to alleged human rights violations in Xinjiang.

As investing in China becomes more challenging, the rationale for choosing a fund manager who can handle these hurdles and invest locally is becoming stronger. Failure to do so might cost you a lot of money. Over the last three months, the iShares MSCI China A ETF (CNYA) has gained 3%, while the Invesco Golden Dragon China ETF (PGJ), which invests in U.S.-listed Chinese firms, has lost 14%.

“Regulation is here to stay,” says the author. “Investors will just have to get accustomed to it,” says Tiffany Hsiao, a portfolio manager for Artisan’s China Post-Venture strategy. “This is capitalism with a Chinese flavor. China is, without a doubt, still a communist country. It supports capitalism in order to spur innovation and increase production, but it is critical for successful businesses to pay back to society—as Chinese authorities will remind you.”

As a result, she believes that investors should look outside the widely owned internet behemoths to discover equities that will profit from the increased regulatory scrutiny that the behemoths will be subjected to. Veteran investors are emphasizing selectivity, looking for firms that aren’t in the crossfire in local markets.

“A firm might have strong fundamentals and exciting potential but be blindsided by government intervention, which is becoming more active,” says David Semple, manager of the VanEck Emerging Markets fund (GBFAX). “Being involved necessitates a higher level of conviction than usual.”

Semple is drawn to firms he knows, in industries that may be impacted by regulation, but not to the extent that investors believe.

One example is China’s efforts to reduce child-care expenses and encourage families to have more children by targeting after-school course providers. Semple, on the other hand, sees potential in China Education Group Holdings (839.Hong Kong), which may make purchases as Beijing compels state institutions to sell associated private colleges.

Semple prefers Tencent, the top holding in his fund, over Alibaba, another holding, among the major internet firms. Tencent has an edge over Alibaba because of its Weixin messaging and videogaming brands, which offer a high-quality, low-cost flow of consumers for its other companies, according to Semple.

According to Martin Lau, managing partner and portfolio manager at FSSA Investment Managers, which manages $37 billion, Tencent has discreetly cooperated with the government’s regulations, with CEO Ma Huateng keeping a low profile. Given the anger directed against Alibaba and Ant co-founder Jack Ma, this is a plus.

The basics of many Chinese internet firms are good. According to Xiaohua Xu, a senior analyst at Eastspring Investments, complying with the rigorous laws on acquiring and securing user data would likely limit their earnings in that sector.

Alibaba and other online businesses, like as JD.com, are accessible to value investors. However, investors’ growth expectations are expected to be recalibrated as Beijing implements new policies and evaluates previous agreements, causing volatility. Furthermore, heavily held U.S.-listed Chinese firms, such as Alibaba, might serve as proxies for investors’ concerns about China.

Despite the red signs, investors should keep China on their radar. According to Jason Hsu, chairman and chief investment officer of asset management Rayliant Global Advisors and co-founder of Research Affiliates, “If you are buying growth, the globe has two engines: the US and China.” However, he points out that the United States is more costly. “And wherever there is risk—and the world perceives China as hazardous, and that bias is deepening—that implies opportunity.”