Investors shouldn’t have been surprised by China’s drastic crackdown on the education and tech sectors last year, according to Michael O'Brien of the Fundsmith Emerging Equities Trust, who said it only confirmed his worst fears about what the ruling Communist Party was capable of.
The MSCI China index fell by a third from its peak in 2021 after the government in Beijing suddenly implemented a range of draconian regulations across numerous industries.
These included a ban on for-profit tuition in core curriculum subjects and foreign ownership in the education sector. Meanwhile, videogame operators were forced to restrict the amount of time minors can spend playing their games online to just an hour a day, on Fridays, weekends and holidays.
Performance of index in 2021
Source: FE Analytics
Other tech companies were hit by a tightening of rules on data protection. This led to one high-profile listing in the US, Didi Global, being told it could not take on new customers within two days of its flotation. Stringent regulations also hit companies in the non-bank lending and property sectors.
Yet O'Brien wasn’t particularly surprised by the moves.
“2021 was a year in which a number of the concerns we have had about investing in China came to the fore,” he said.
“Needless to say, these included concerns about overseas listings, regulation across a number of sectors, slower rates of economic growth and a controlling political party returning closer to its Marxist origins.
“We continue to take the view that China is governed by the Communist Party with its own interests of ideology and self-survival at the forefront of policy making, whether it be social, economic or diplomatic.”
To prove his point, he noted that the private education sector in China was estimated to be worth more than £100bn per annum, yet the government was willing to see it all but wiped out through an immediate ban, with no right of appeal.
He added that with Xi Jinping likely to have his term in office extended later this year, China’s autocratic approach to governance won't be changing any time soon.
“Simply put, the rules governing the operation of the 'free market' in China are arbitrary, not transparent and not subject to legal challenge,” O'Brien added. “We do not expect this to change shortly.”
“Across our investment careers, we have seen multiple examples of regulation in emerging markets that simply defies economic or market logic. Over the past two years, this has been exacerbated by the political imperative of the Communist Party of China, which is moving increasingly back to its harder line, Marxist-derived roots.
“From an investment point of view, although China's economy is likely to continue to open up, it will do so very much in the interests of the party. Do not expect favourable treatment as a foreign investor.”
The manager added that problems around governance were not limited to the role of the state in China. He said he had found an inordinate number of companies with inadequate governance, questionable accounting standards and issues over ownership and voting rights, as well as poor capital allocation.
“As we have previously stated, we will not invest in a Chinese company just because it is a 'good business by Chinese standards' as those standards are not replicable across the markets in which the Company has the ability to invest,” he explained.
Yet the manager does not avoid Chinese stocks entirely. Although he is underweight the world’s second largest economy, at 15.7% of his portfolio compared with 31.8% from the MSCI Emerging Markets index, it is still his second-largest regional position, behind India at 53.3%.
His Chinese holdings include companies in the battered tech sector, such as videogame developer NetEase. The appeal of the company to O’Brien is its focus on creating games with longevity in mind, allowing them to become long-established franchises, typically with follow-on titles.
For example, NetEase launched its first PC game Westward Journey in 2001, yet in 2019 this was the sixth-highest ranked mobile game in China in terms of user spending.
“The group is targeting to derive 30% of its gaming sales from international markets,” the manager continued.
“2022 will see the international launch of Harry Potter: Magic Awakened after a highly successful 2021 launch in China where it debuted at number one in the iOS charts. NetEase has a considerable net cash position on its balance sheet, which will allow it to develop both its gaming operations and other businesses such as streaming.”
He also continues to hold Tencent, even though this was the fifth largest detractor from the trust’s performance last year, after its revenues were hit by the aforementioned videogaming crackdown.
“In addition, scrutiny of apps, content of chat sites and the handling of data have all become issues for regulators in China,” O’Brien added.
“We believe, however, that Tencent will be able to adapt to these regulations and we also believe that there remains significant opportunity in its investment portfolio.”
Fundsmith Emerging Equities Trust has made 9.2% since launch in June 2014, compared with 52% from its MSCI Emerging Markets sector and 31.9% from its IT Global Emerging Market sector.
Performance of trust vs sector and index since launch
Source: FE Analytics
It is on a discount of 15.1% compared with 8.1 and 8.7% from its one- and three-year averages and has ongoing charges of 1.3%.