Investor uncertainty in China has been elevated over the past few years due to several factors, perhaps nowhere more so than in the tech sector. For some time, a combination of global and local policy factors has made the investment landscape complex.
However, recent developments, in particular China’s shift away from its zero-COVID policy, have reignited our confidence in the internet sector in China. While risks, of course, remain, we believe there are opportunities to be found among Chinese internet companies and prudent investors may be able to access them effectively with a diligent, bottom-up approach.
Exogenous challenges and maturing growth
In our view, there have been three key risks weighing on Chinese internet companies: geopolitics, local policy, and slowing growth.
The geopolitical climate has proved challenging for tech companies in China. The Biden administration introduced additional restrictions in 2022 on semiconductor and semicap equipment sales to China. Progress in advanced tech, such as AI and autonomous vehicle development, is potentially impacted. My belief is that while domestic relative competitiveness will likely go unaffected, the restrictions may make it more challenging for Chinese companies to enter foreign markets — especially in areas that require high compute power, like cloud computing, a byproduct of being unable to access the most advanced hardware.
Recently, there has been progress between the Public Company Accounting Oversight Board (PCAOB) and China- and Hong Kong-headquartered public accounting firms, which suggests that avenues for cooperation remain. The PCAOB announced that it had secured complete access to inspect and investigate audit firms in China and Hong Kong — an incrementally positive development that also reduces the risk of delisting for Chinese technology ADRs.
That said, we don’t expect the geopolitical tension built up over the past few years to dissipate overnight, so foreign investors may think twice before buying Chinese stocks. There may be a future where ownership of China tech companies listed offshore shifts to local shareholders, but this would take time. Alternatively, companies could relist in the A-share market, but, in my view, this could also be challenging.
Aside from geopolitics, there are also local policy risks. On one hand, 2022 marked a focus on common prosperity as the government announced a shift toward a new model for economic development, However, policymakers are weighing support for the economy amid a reopening of borders and retirement of its zero-COVID policy.
While it would be prudent to presume that regulators remain vigilant, there is growing evidence to suggest that the regulatory cycle for Chinese tech companies has inflected to an easier environment. For example, recently a leading fintech company received approval to restructure parts of its business that were under scrutiny — a marked change after more than two years of headwinds.
While it might seem that regulatory winds have shifted, we believe that it pays to assess each tech subsector for vulnerabilities. Industries that are focused on entertainment like live streaming and short video, for example, could be more vulnerable than others that are deemed to contribute more strategic value. These industries could see unexpected, material risks appear unannounced, like they did last year in this sector.
Finally, we think there is also reason to be cautious about Chinese internet companies’ growth potential as an industry at this point. Penetration rates in the internet-services space have grown significantly. Competition generally remains high — although less cutthroat — with better rationalization. While there is room for growth ahead, it will most likely slow down compared to previous years. Investors will need to assess whether the growth profile of companies in this industry remains attractive enough to discount issues such as variable-interest entity (VIE) structures, policy impact, and geopolitics.
What’s the near-term opportunity?
China’s reopening and economic recovery from its zero-COVID policy has bolstered our optimism about Chinese internet companies. Late last year, these companies’ stocks had very attractive valuations with strong balance sheets and expanding profitability, reflecting very low investor sentiment. At the time, we believed low valuations suggested that the market could reassess the multiples for certain businesses as investors turn more positive; companies were flush with cash and were returning capital to shareholders.
It’s early in the new year, but this reassessment is starting to play out and our outlook is more sanguine. The favorable backdrop of accelerated reopening, relative economic strength versus developed markets, and potential easing of regulations paired with attractive valuations may bode well for Chinese internet companies.
Potential government stimulus could make the investment case even more attractive. Starting off the year, a rising tide is thus far lifting many boats, but investors may wish to consider which areas of the market could benefit most from policy change. We’re most optimistic that e-commerce and local services may benefit from potential stimulus. Software companies could also be reasonably well positioned for longer-term growth and may benefit from domestic substitution.
Bottom line on investing in China
It’s important to acknowledge that, when it comes to investing in Chinese internet companies, there are several potential sticking points to bear in mind over the longer term, but it’s also critical to acknowledge opportunities that exist as growth accelerates. Within this space, there are attractive companies that are exposed to potential stimulus or the reopening of the broader economy.
Taking a bottom-up approach, seeking out specific stocks with attractive valuations and setup, rather than taking broad-based exposure, is, we believe, the right strategy to navigate a volatile, but potentially opportunity-rich investment environment.
With so many nuances at play here, in our view, investors seeking exposure to China should remain nimble and may benefit from working with an active manager able to evaluate the complicated political and economic landscape holistically.