Chinese stocks have been falling practically all year. The list of unknowns has grown to levels to make even the most value-conscious growth investor throw in the towel on the Chinese market as a whole.
Though Chinese tech stocks seem rich in value, the perceived risks of investing in the Chinese market have grown considerably with time. Delisting fears alone may be too great for any cautious investor to get in on such popular internet behemoths like Alibaba (NYSE: BABA), Tencent Holdings (OTC: TCEHY), or Baidu (NASDAQ: BIDU).
Smaller, higher-growth tech stocks (think Pinduoduo (NASDAQ: PDD)) seem even harder to get behind, given their amplified volatility and greater risk in the face of a global economic downturn. Also, let's not forget about the risk of accounting irregularities.
The Difficult-to-Fathom Risks of Investing in Chinese StocksThough the list of worries seems to grow, rather than shrink, by the day, uneasy investors may be better off forgoing the high-growth market altogether. For those ready and willing to embrace the added regulatory risks of owning Chinese stocks, I think there's much value to be had.
At the end of the day, China is one of the fastest-growing markets out there, and the dominance of its top tech companies could rival that of the American big tech companies we all know and love. Indeed, being at the mercy of the Chinese government is never a great feeling. Regulatory risks are difficult to factor into a Chinese stock's valuation.
Regardless, I think a lot of such regulatory risk is baked into shares. Any unforeseen easing of regulations could induce massive upside across the board. Of course, speculating on when such exogenous events will occur is a fool's game. If you've got the time horizon (at least 10 years) and are comfortable (preferably with some experience) in catching fast-falling knives, actively avoiding Chinese stocks could leave a lot of long-term growth on the table.
How to Reduce Risk When Buying Chinese Internet StocksThe Chinese internet stocks, I believe, are worth dollar-cost averaging (DCA) into as they crumble. Their growth profiles could have the potential to be unmatched, especially once the Chinese economy recovers and firms like Alibaba look to international markets to add to their growth.
Now, the Chinese market already has a world of growth opportunities for a firm like Alibaba, as it pursues new market verticals. Like American big tech companies, top Chinese internet giants are expanding their businesses to encompass new markets. Payments, video games, e-commerce, hardware, and all the sort, the Chinese stocks do, in many ways, have growth profiles that resemble the big tech companies on steroids.
The only piece of hair on their long-term stories lies in regulatory risks. Chinese companies must comply with regulations, or the penalties for skating offside could be enormous. Last year, Alibaba was made an example as it took a $2.8 billion fine to the chin for anti-competitive behavior. Alibaba has committed to change, and other Chinese tech firms are likely to follow.
There's no way to truly eliminate regulatory risks. For investors, the best way to go, I think, is with China's top tech giants. Alibaba and Tencent are two top dogs that are down around 78% and 68% from their all-time highs.
Fundamentals suggest both firms are deeply undervalued. That said, regulatory risk warrants a lofty discount on shares versus the fundamentals. It's hard to tell how much regulatory discount shares should command.
At this juncture, it seems like such risks are at a high point, with Chinese stocks down around the same as a Cathie Wood innovation stock. With valuations in the gutter, Chinese stocks may be worth a contrarian bet for those who understand the magnitude of the risks they'll bear.
The Bottom Line on Chinese StocksThough there are so many intriguing options in the Chinese market, I think dollar-cost averaging into mega-cap or market-weighted ETFs like the KraneShares CSI China Internet ETF (KWEB) are the best way to go for those willing to stomach amplified pain going into a recession year.
The risks with Chinese stocks are high and hard to fathom. However, so too are the potential rewards.
An ETF option would be best for investors looking for a smoother transition should major U.S. exchange delistings cause a conversion of U.S.-traded shares to Hong Kong shares.
International investing can be enriching, literally and figuratively, but it must be done selectively and only after conducting a great deal of due diligence. Sometimes, a big change - or the lack thereof, in China's case - can make investing abroad challenging and unprofitable.
What U.S.-based financial traders need to remember is that the climate for businesses in China is quite different than it is in America. In a nation where collectivism and loyalty to the state are prioritized, one can't simply assume that competition and free markets will be encouraged or that market-critical information will be readily available or accurate.
Amid this sometimes murky and confusing backdrop, China recently marked a historic moment - and yet, the nation's technology-focused business isn't likely celebrating now. So, before you embark on a dip-buying expedition based on rock-bottom equity prices, be sure to bone up on China's political pitfalls, as they're bound to impact every investor's profit-and-loss profile.
Xi Cements ControlIn the U.S., a two-term presidential limit is written into the nation's Constitution. In China, however, the rules were recently shown to be more "flexible," as President Xi Xinping (commonly referred to as just "Xi") secured a third term.
You've surely heard the word "unprecedented" used many times since the onset of COVID-19. You're going to hear it again as Xi cements his leadership position, though it might not be strictly accurate in this instance. By confirming his third term, Xi will be China's longest-serving president since Mao Zedong.
As you may recall, China under Xi has been security-focused to the point of being business-restrictive. Xi was in power as Beijing halted the IPO of Ant, the financial-technology affiliate of e-commerce giant Alibaba (NYSE: BABA). Around that same time, China's government under Xi launched an antitrust investigation into Alibaba, along with a broad-based, security-centered crackdown on the country's biggest internet firms.
This isn't to suggest that other nations, including the U.S., don't enforce antitrust and national-security regulations. Indeed, U.S. regulators have considered delisting a number of China-based businesses from American stock exchanges. Thus, the ongoing Sino-U.S. tensions are already enough to dissuade some cautious investors from venturing into U.S.-listed Chinese stocks now.
That's perfectly understandable, as the delisting threats aren't always top-of-mind in the financial headlines, but they never really went away completely. Plus, there's the lingering threat of a Chinese invasion of Taiwan, which undoubtedly would incur a swift response from the White House and fray the already tenuous relations between the two world powers.
China's Market RoutConfirming Xi’s third term at the 20th Chinese Communist Party Congress resulted in more than one relatively "unprecedented" event taking place. Sure, it meant that Xi would break with the nation's two-term tradition. However, it also resulted in Hong Kong’s Hang Seng Index, a major stock market gauge in China, closing down 6.4% on October 24 and marking its worst single-day decline since November 2008.
Hang Seng Index. Source: TradingViewIf you think that's mind-numbing, get a load of this: The Nasdaq Golden Dragon index, which tracks U.S.-listed shares of China-based businesses, plunged 14.4% after Xi secured his third term. This was the index's steepest single-day decline on record.
What does this tell us? The financial markets might be irrational sometimes, but they're not ignorant. Traders know full well that another Xi term means a continuation of highly business-restrictive and sometimes unpredictable policies. It also means geopolitical uncertainty as Xi may still have his sights set on Taiwan; plus, he may now feel emboldened to tighten his grip on China's already-struggling tech firms.
Knowing and fearing all of this, financial market participants promptly divested their shares of China-based companies, tech-focused and otherwise.
Understandably, investors are nervous about Xi's political clout. Reportedly, China's government has been stacked with Xi loyalists in practically every top position. Hence, any realistic chance of pro-market reform is effectively null and void.
Xin Sun, senior lecturer in Chinese and East Asian business at King’s College London, further articulated the market's concerns. Specifically, Sun suggested it's unlikely that anyone in China will challenge any “policy mistakes” that Xi might make that could inhibit growth in the country's technology sector.
Takeaway: Play It Safe as China Faces ChallengesIt's one thing to invest in a U.S.-based business that had a rough quarter or two; it's another matter entirely to venture into a tech market where competitive practices are hamstrung by all-powerful regulators. So, ask yourself: do you really want to bet on businesses that will have to fight an uphill battle against a sometimes business-hostile regime?
The problems besetting companies like JD.com (NASDAQ: JD), Tencent (OTC: TCEHY), and Alibaba don't have to become your problems as an investor. There's no need to wager on the growth of a group of tech firms, after all, in a region where growth isn't necessarily the number one priority.
When Xi Jinping began his first term as the President of China in 2013, the country’s economy and markets were on the rise, and their future looked as bright as ever. In the years that followed, China’s economic progress was astounding, and the idea that China would soon overtake the U.S. as the greatest economic power was perceived in the West as an established fact. What supported this belief was also the meteoric rise in the Chinese stock market, with Chinese companies achieving huge market caps, which rivaled their U.S. counterparts, and Chinese equities gaining growing inclusion in the international stock indexes.
The West: Close Your Nose and InvestChina’s economic growth and market surge were so dazzling that the West collectively ignored the encroaching authoritarianism of the Great Leader Xi, whose tenure at the helm of the Communist party was tainted by militant nationalism, a fast deterioration in human rights (including the semi-genocide of Uyghurs), mass surveillance and detentions, ever-rising censorship, and a cult of personality developing around Xi - a quite typical path to dictatorship.
The way China dealt with the COVID-19 epidemic, including such horrible incidents as welding people’s doors from outside to force total lockdowns, showed clearly what many in the West have already started to suspect: that China was becoming a totalitarian state - again.
Meanwhile, Xi Jinping, who was perceived as a free-market enthusiast at the beginning of his career as China’s leader, reversed his stance toward lessening the government’s involvement in the economy. His government installed Communist Party officials inside private firms, sometimes taking them over entirely to the hands of the state. The government officials held the credit tap handle, deciding how much credit and at what price should be given to the private sector by the state-controlled banks.
However, Chinese “state capitalism” has survived many hurdles, including a trade war with the U.S., and its growth rates continued to outperform free-market economies (if Chinese statistics were to be trusted). Thus, the country’s stock markets still beckoned to Western investors, attracting billions of dollars and euros that were bet on the continued rise of its highly successful corporations, such as Tencent (OTC:TCEHY), Alibaba (NYSE:BABA), ByteDance, and others.
The Enemies of The State from AliExpressHowever, the suggestion that a country can be politically authoritarian while maintaining free capital markets got a shattering blow in 2020 when the Communist party issued a new set of rules for private companies, requiring them to serve the state. A few weeks later, Xi personally blocked what was expected to be the world's largest IPO, Ant Group’s $37 billion offering. Prior to the IPO, Ant’s founder Jack Ma criticized the Communist party’s economic policies - and the reckoning was fast and furious.
Ant Group was just the beginning of a crackdown on China's high-flying firms, as Xi increasingly viewed successful corporations as unreliable and untrustworthy rivals to his tightening grip on the country. In recent years, it looks like Xi has been on a mission to destroy all private economic initiatives, sector by sector.
Thus, in 2020, Beijing rolled out a policy aimed at preventing a burst of China’s real estate bubble - but the sudden pivot in government-ruled credit availability hastened the crash, leading to a wave of defaults including those of large developers such as Evergrande (OTC: EVGPF) and Kaisa (DE: KG5), as well as a crash in property prices. The Chinese real estate sector stands at about 30% of its GDP, posing a great risk to the economy, already reeling under Xi’s “zero-COVID” policy and the global slowdown.
Another state-induced crisis arrived in 2021, as Xi’s China continued to tighten its grip on the tech sector; the Chinese president’s attack on the “disorderly expansion of capital” clearly showed the path ahead. Actions followed the slogans, first with a torrent of regulatory blows and antitrust swings aimed at tech platforms like DiDi Global (OTC: DIDIY), Meituan (OTC: MPNGF), and Pinduoduo (NASDAQ: PDD), and then dealing a knockout to the Chinese education tech sector.
Online schools were the one place where the state was not controlling every aspect of the curriculum as they'd been doing with regular schools. The Communist party was clearly unhappy with that fact - so the authorities banned for-profit online education centered on public school and university curriculums. Once the darlings of Wall Street and venture capital, edtech firms like New Oriental Education and Technology Group (NYSE: EDU) and TAL Education Group (NYSE: TAL) were out of the business of teaching outside of the party-approved lines.
You Can’t Have Both Economy and CommunismDespite the fact that the communist crackdown on economic freedoms has been going on for a few years and clearly isn’t ending anytime soon, many Western investors have remained optimistic about Chinese stocks. Even the poor performance of Chinese stocks hasn’t discouraged the China optimists: with all the declines, S&P 500 (SPX) is up around 9.5% in the last two years; meanwhile, the Chinese Hang Seng index is down 35%. However, the ongoing sweeping change is expected to sink in now after the Chinese stock market bloodbath that followed last month’s 20th Communist party congress.
SPX (blue) vs. Hang Seng (orange). Source: TradingViewXi Jinping’s speech and his choice of a new leadership team unveiled his tightening grip over the military and economic powers, clearly signaling a focus on security and state control rather than on business-friendly policies. Mr. Xi has cemented his one-man rule, consolidating his hold of all aspects of life in China - and the wording of his speech doesn’t bode well for the Chinese private sector and its investors. Obsessed with power and security, he is more focused on quashing all ideological and geopolitical challenges than on economic progress.
The agenda that is now expected to mark the way forward is “common prosperity” - reminiscent of all the communist slogans from the days long past that ended with no prosperity but with common suffering. Xi has signaled to move toward the concentration of the state’s role in the economy, which implies that the role of private companies will become muted.
The hopes of China-optimistic investors that China will successfully combine socially restrained capitalism with “reformed” communism were shattered at the Communist Party congress in October, where it was as much as stated that China will aim to dominate the world under the eternal rule of the Great Leader Xi.
Poetics aside, it should be clear now that China is tilting away from free markets and back toward ideologically driven centralized planning. So it is not surprising that the shares of Chinese companies listed in the U.S. fell on the day of the Congress, while Chinese shares traded in Hong Kong tumbled to their lowest level since 2008. Their investors suddenly understood that they could be saddled with regulatory restrictions or even delisted at any moment on the whim of the Politburo. Frustrated international investors pulled a record $2.5 billion from mainland China stocks on the day of the congress alone.
China is Uninvestable AgainSurrounded by his crew of loyalists, autocratic Xi will meet little to no resistance to his efforts to pivot the country’s focus away from economic growth toward redistribution and state control. As God only knows which sector will draw Politburo’s ire, leading to a sudden loss of value, Chinese stocks look uninvestable for any reasonable investor.
Of course, in the short run, all kinds of oddities are possible. However, as a rule of nature, in the long run, a free economy and free markets can not work without a free society. Communism - all its versions, from Stalinist to Xi-ist - doesn’t seem to work, neither politically nor economically. Having established that, investing in Chinese stocks now would be akin to betting against the casino: it may work until the house changes the rules.