The Hang Seng TECH Index closed this morning in Hong Kong at a new low and Tencent and Alibaba, among the most substantial businesses in China’s new-economy sector, were down over 40% and 60% from all-time highs. It’d be fair to say then the China tech and new-economy sectors are not happy places.
Valuations based on hubris and over-optimism are now transitioning from fantastical to realistic and in anticipation of the next iteration, from realistic to cheap, those with the skills and patience may wish to begin the process of sorting survivor-wheat from hopeless-chaff.
To do this let’s first consider what’s ailing these sectors and, in so doing, feel past some of the now-materializing risks. Buying the stock of a company with an innovative business model involves more risk than buying into an established business, but in China these risks are acute.
When it all comes together for an innovative business rewards for investors can be stratospheric; but before winners emerge many iterative models are crushed and in China being on the wrong side of this creative-destruction is more likely to be a company’s fate than elsewhere.
To be more specific. Below is a list of five common reasons stocks of new-economy businesses founder and why, in China, these risks are greater.
Unprofitability – So called ‘Flywheel’ companies in China (a good recent aside from The Economist here The Flywheel Delusion) suffer from a China-problem investors there have been acquainted with forever; intense competition funded with bottomless-wells of cheap capital. In the past when a local government saw a business enjoying success in another locale they would call on pliant local banks to fund the creation of facsimiles. Add to that still-present dynamic the entrance in recent years of venture capital and private equity investors. The effect of this, for companies whose model is to buy a market position via an unprofitable start-up period, is to push their profitability-horizon farther out than elsewhere.
Some Models in China Just Don’t Work – Some models work fine on paper but, in the real world, they just don’t. Consumer preference and cultural norms are different in China than in the West because, well, they just are. A pitch to investors in Boston citing working examples in operation in their backyard may be flawed because in China they don’t/won’t ‘take’. [Not tech but a great example of this nonetheless is Mattel’s struggles with Barbie in China Why Barbie Stumbles in China]
Scams – Two words; Luckin Coffee. In another market more intense scrutiny would have been been applied to the operators (perhaps?). Good industry data might have allowed for more realistic market analysis and the presence of legacy operators may have facilitated better cross-sectional analysis. The problem here though wasn’t immature markets or poor analysis, it was malfeasance. When management falsify data investors have little protection and in China this is often especially hard to spot.
It Works! But It’s Expensive – There’s an iron-rule when investing in stocks; the price paid must ultimately be reconciled to the underlying company’s earnings. Growth and value investing are two sides of the same coin in this respect. Value investors try to buy a dollar of earnings for the best possible price and a growth investor does the same. The difference is the calculation each make about when and in what number those dollars are going to show up. Unfortunately, because potential future winners are all-too-often obvious a fancy initial price needs to be paid to acquire them which ends up producing a poor return over the life of the holding. This conundrum is especially bothersome in China as the panel of potential winners is smaller than the same roster available in, say, the U.S.
Regulation – This is an always-and-everywhere risk but in China, as the fortunes of the EdTech complex demonstrated earlier in the year, this risk can fructify quickly and with profound consequences. The opaque nature of policy formation, the wink-and-nod system that forces all business in China to operate in a twilight zone between rules and laws and a political preference for measured progress (in all things) conspire in China to create a landscape where regulatory risk is, often, not quantifiable.
A Way Forward
Many Chinese tech and new-economy companies listed today will be around in ten and more years time, and not a few will be more profitable and sustainable than today.
The task now, then, is to ‘simply’ identify the long-term survivors with durable business models that aren’t scams. Companies whose stocks are priced offering significant upside to future earnings and where regulatory risk is least. If that all sounds like a bit of a tall order, it’s because it is.
Investing is hard and requires diligence over long hours of patient analysis, something buyers to date are discovering the hard way. For those whom careful discovery and thoughtful review is an established practice though now is a good time to begin engaging skills.
But there’s no hurry. To remind, it took the world’s greatest living investor 36-years from Apple’s IPO in 1980 to be persuaded to take a stake. Sure, he missed out, but returns from his 2016 entry haven’t been too shabby. Especially considering the lower risk company bought in 2016 compared to the often-troubled scrapper it’d been before then.
There’s an important lesson here. Now may be the time to get to work but we may be years, not months, away from seeing the kind of stability Mr. Buffet finally managed to take advantage of in Apple.
However, if the journey of a thousand li begins under one’s feet (千里之行，始于足下）now’s the time to set off towards a better understanding of sectors that aren’t going away, doubtless contain more good companies than bad and where, here and there, stock prices are beginning to line up with long-term earnings potential.
Nial Gooding
December 6th, 2021