Investors in the Chinese technology giants Alibaba and Tencent have been rewarded over the past several years with strong growth, but the two stocks are now down 50% and 40% respectively from their 2021 highs.
The Chinese government’s recent regulatory crackdown has targeted these two technology firms particularly hard, levying fines, imposing restrictions on their businesses and mandating donations in the name of common prosperity.
Andrew Swan, head of Asia excluding Japan equities at Man GLG, described what is going on in China as a “controlled explosion” and expects that returns from the technology giants will be capped going forward.
“The push towards common prosperity in China that has evolved through the course of the year is not too different to what we're seeing in other markets,” he said.
“It's a reflection of growing inequality as a result of ultra-loose monetary policy and inflation of asset prices over a long period of time without any real economic growth or income growth.
He said that the political and economic difference between China and the rest of the world means that when there is an objective for policy “it tends to be pretty effective”.
This push to address inequality in society and redistribute income has resulted in very significant changes to the outlook for these technology companies and many other industries, he noted.
“Those high-flying industries that we've seen over the years, as they start to get more regulated and face lower growth and lower returns – the market has been very quick to price in that changing outlook,” Swan said.
“The markets are assuming this will be a controlled explosion in many ways,” he added. “There is a desire for policymakers to break the implicit guarantees in the system and the markets at the moment would suggest that they're on track to do that.”
Performance of Tencent year-to-date
Source: Google Finance
Kamil Dimmich, manager of the Pacific North of South EM All Cap Equity fund said that it was inevitable that there would be a correction in the big technology giants, but now presents a good buying opportunity.
“Companies like Alibaba and Tencent were essentially taking over China, and people were extrapolating these growth rates, continued margin expansion, and essentially giving them a valuation that implied they would become monopoly businesses in China,” he explained.
What is happening to the technology giants is not dissimilar to what happened to Microsoft in the early 2000s, in his view.
“No government, it doesn't matter if it's China or in the West, wants a market being distorted by a monopoly,” he said. “And these guys were definitely heading in that direction.
“They were abusing some of their position by engaging in various practices such as buying up smaller competitors just to shut them down – exactly what Microsoft used to do, and it got in trouble for that.”
The manager believes that the increased crackdown scrutiny is likely ending soon and has therefore for the first time ever, bought shares in Alibaba for his fund.
“Whenever I hear people saying something's uninvestable that's usually a buying opportunity,” he said. “I would suggest that we're closer to the end of this increased crackdown scrutiny.
“The Chinese government is very clear; it is not trying to forbid private enterprise and private business. The model has worked incredibly well for the Communist Party. All it is trying to do is re-establish a little bit of control, and yes that's not great for business.
“You just have to now assume that Alibaba and Tencent will not be able to generate supernormal profits forever off their monopolistic position and continue growing.”
Performance of Alibaba year-to-date
Source: Google Finance
Whilst Alibaba and Tencent will likely face headwinds, other names will be less affected, according to David Older, head of equities at Carmignac.
“I think what's important is that we're seeing the rulemaking be made public for each sector, and that's allowing investors to have clarity as the effects on these business are analysable,” he said. “This is what the market needs, and we really think that this will only improve from here.
“You've probably read certain pundits say China is uninvestable now because there's a lack of clarity – we think that clarity is coming.”
He highlighted that 40% of annual global economic growth comes out of China, and against a backdrop of slowing global growth he suggested that this was particularly important to keep in mind.
He said: “Even though it's slowing growth, it is still the fastest growing developed market in the world – and our belief is that investors will not be able to ignore that growth in a slowing growth backdrop.”
“Now that's not to say that we're just investing in China blindly, I think there are some areas that we would actively avoid.”
Although Alibaba and Tencent are going to have their future profits affected by the government’s regulatory crackdown, a company like JD.com will be better positioned, he said.
Performance of JD.com year-to-date
Source: FE Analytics
“JD.com is the number two e-commerce company in China after Alibaba, but a very different business model,” he said.
One issue with Alibaba is that its platform has been plagued by fraudulent fake products, which the government is looking to regulate.
JD.com on the other hand has close to 100% of its business as a first party retailer – controlling its own inventory with no fake or fraudulent products on the platform.
Older said: “Additionally, JD.com controls all of its logistics. Its warehouse and delivery people are employed by the company, and it is well compensated with social security.
“The result of all this is a customer delight that our survey work in China would indicate is much higher than it is for other ecommerce players, and this is what the government wants. They want companies are providing benefits to society.”