The effect of China’s corporate crackdown on South African investments
“This is a show of force from the Chinese government, saying, ‘We’re going to reel in these tech giants and their unruly behaviour,’” says Prof. Michael Sung, founding co-director of the Fudan Fanhai Fintech Research Center at Shanghai’s Fudan University. “Because now they’re big enough to have systemic risk.”
The crackdown poses a threat to the way that China’s tech sector has historically enlarged itself and has potentially serious consequences for wider investor confidence.
With the crackdown on corporate tech, educational reforms and demographic growth rate concerns, we look a bit deeper into the Stock Giants.
Naspers, Prosus, and the decline of Tencent
Tencent, the Chinese internet giant and the largest contributor to the profits of South African-listed Naspers and Prosus is off more than 40% from its highs earlier this year. This decline in the market value of Tencent has weighed on the share prices of Naspers and Prosus and caused investors to question the investment case for these companies. In an effort to ostensibly increase oversight and promote fair competition, China instituted sweeping reforms across a variety of sectors over the past few months. But these moves have brought about uncertainty and caused global investors to flee from companies with exposure to China.
Alibaba, Ant, and the disappearance of Jack Ma
The recent wave of regulatory investigations was ignited in November of 2020 when Ant Group, the digital payments company affiliated with Alibaba, was blocked from becoming a listed company in what would have been the world’s largest IPO in history. This came shortly after Jack Ma, the founder of Alibaba, delivered a speech in which he appeared to criticise the Chinese authorities for its heavy-handed approach to financial sector regulation. Ma disappeared from public view for several months as an investigation was launched into Alibaba for anti-competitive behaviour regarding its e-commerce platforms. Alibaba had lost over $270 billion of its market value by the end of 2020, and when Ma resurfaced in a short online video, its stock jumped by more than 7% on the same day. Alibaba was subsequently slapped with a $2.8 billion fine for violating China’s market regulations.
Didi, Tencent Music, and for-profit education
The next wave in the regulatory crackdown came in June 2021 when Didi, a ride-hailing app popular in China, came under the scrutiny of Chinese regulators for its pricing and competitive practices. In July 2021, shortly after the company went public on the New York Stock Exchange, the Cyberspace Administration of China ordered app stores to remove Didi from its platforms citing issues with how it handled sensitive user data.
A few days after the Didi debacle, a division of Tencent trading separately as Tencent Music was informed that it had 30 days to relinquish the exclusive rights it held with certain record labels. Tencent owns the top three music streaming services in China and enjoys approximately 80% market share. The actual impact this will have on Tencent Music is not yet clear, but the exposure in the larger Tencent group is relatively minor (we estimate only around 4% of Tencent’s earnings to be directly at risk).
Apart from this announcement, scrutiny around mergers and acquisitions has also increased. Two Chinese video gaming streaming platforms, Huya and DouYu, abandoned a proposed merger after regulators blocked the deal. Tencent owns 37% and 38% of Huya and DouYu, respectively. Again, the direct profit impact on Tencent is negligible, but the trend is concerning to investors seeking clarity and certainty from the regulatory regimes in which their companies operate.
Perhaps the most radical recent action taken by Chinese regulators is the decision to effectively ban for-profit education in China. As a result of the news, the shares of New Oriental Education and TAL Education, whose whole business models depend on for-profit education in China, suffered 70% to 80% share price declines in a matter of days. The controversy around this action continues to play out daily.
Why the crackdown?
Part of the motivation for the crackdown revolves around the power of big tech companies and the influence they have over their users through their platforms and the personal data they have access to. Monopolistic behaviour arises when too few players dominate a market. The Chinese Communist Party (CCP) feel that large technology companies could exploit Chinese consumers and that they should be reined in. Similar concerns exist in the United States over the might of its own giant technology firms, although the impact of regulation has not been as abrupt or as forceful as in China.
One explanation for the more forceful action by Chinese authorities is that China is playing regulatory catch-up, particularly with regards to its internet sector. The CCP will need to balance its desire to keep local giants under control with the desire to compete as a technology leader on the world stage. Reforms in the education sector may however have more to do with China’s demographic headwinds than corporate crackdown.
In the early 1980’s, China imposed strict population control measures whereby parents were allowed to have only one child, with a few exceptions. This became known as the one-child policy and, as expected, lead to a dramatic decline in the population’s fertility rate. China’s fertility rate dropped from over 6 births per woman in the mid-1960’s to around 1.6 in the 2000’s. The one-child policy was finally abolished in 2015 in favour of a “two-child policy” after it became clear that the consequences of a rapidly ageing population spell doom for the long-term future of the Chinese economy. China’s fertility rate has not increased by much since the one-child policy was abolished. The government has recently introduced a “three-child policy”, but there is reason to be sceptical of the significance of this policy.
According to Chinese consumers, the number one barrier to having more children is the cost associated with raising them. The CCP likely sees the ban on private education as a way to ease the burden of education costs on parents, thereby encouraging them to have more children. The success of China’s attempts to solve its demographic problems will take decades to play out.
Where to from here?
Autus Fund Managers has been lowering the funds’ exposure to China since last year when the regulatory issues became a concern. We have had no exposure to the worst-hit companies (including Didi and the education companies), and we have no intention to enter into speculative positions where this level of uncertainty exists. However, we do not believe that complete disinvestment from China is appropriate or necessary at this stage. With a population of over 1.4 billion people, China still has a lot of potential for companies that have experience operating in the domestic environment.
The demographic headwinds are not necessarily unique to China, and some industries could even benefit from an ageing population. Although Beijing may struggle to find a balanced approach to implementing stricter regulation, it is unlikely to destroy its national champions in the process. Furthermore, the intensely negative reaction of the market could turn into a buying opportunity for long-term investors.
Only time will tell how these companies will emerge from the prevailing difficulties. As always, calculated risk-taking and fundamental stock-picking is the approach we will continue to take when it comes to investing, including investing in China.
In times of great uncertainty, one thing that you can be certain of is that our team at Autus Fund Managers are continually working together to safeguard the long-term success of the company and its stakeholders.
As Covid19 and the effects of adjusted level 4 continue to take their toll on South Africa, no one imagined that we would face extensive economic destruction caused by violence and looting in some of the financial hubs of the country.
The government has spent a few years fighting for foreign investment to reduce the unemployment rate and hike the economic growth, only for the effort to be burned down by the lawlessness on the ground.
While foreign investors are likely to sit on the sidelines to see how South Africa responds to the current situation, South African companies will move quickly toward restoring what they have lost. It will be the deciding factor for international investors and whether they put their money back into SA, according to Jacko Maree, who served as Standard Bank Group chief executive for 13 years.
“That is what foreign investors will look at primarily because when you’re looking at building a factory, or a mine or renewable energy plant, the destruction of physical property will be your biggest concern,” he said.
In eThekwini alone, more than R15 billion worth of damage to property and equipment has been estimated, according to eThekwini ECOC, and more than 40 000 businesses have been affected. Given rise to real concerns that the instability will affect investor confidence at a time when South Africa needs it the most. But some business analysts have been less pessimistic than expected.
“I don’t think this will have a material effect on investors as they understand the risks. We are an attractive market with sophisticated institutions and financial markets,” Nick Binedell, the founding director of the Gordon Institute of Business Science of the University of Pretoria, told Independent Media.
The bulk of the damage caused by the riots accrues to the property and retail sectors. Redefine Properties Limited (Redefine), a South African-based Real Estate Investment Trust (REIT), indicated that 2% of their overall property portfolio is impacted directly by the unrest but stressed that they are comprehensively insured.
Pepkor noted that 489 of their stores – including the HiFi Corporation, Rochester, Shoe City, Pep and Ackerman brands were looted and damaged, equating to 9% of their retail footprint. But, the process to clean up, reopen and restocking stores have started. With one Pepkor distribution centre also looted, the supply chain remains severely disrupted, but the vast majority of the stores remains operational and insured for damages and losses incurred. Regardless, Pepkor share price was up 1.3% and closed on R19.36 on Friday, 16 July.
The unrest may also have had a role to play in the decision by Moody’s to downgrade the debt ratings of three of South Africa’s municipalities, namely City of Cape Town, City of Johannesburg, and City of Ekurhuleni. Most sectors of the JSE are relatively unaffected by the unrest, mainly due to the offshore nature of the companies’ operations and the fact that the unrest was contained to only some parts of the country.
A few mining companies have declared force majeure on some of their customer contracts due to disruptions on the roads and ports in KZN. However, these contracts form a small part of the operations of the mining companies. For the most part, therefore, no major changes in investment strategy are warranted at this point.
The recovery efforts we have seen are indicative of the tenacity of South Africa and its people. South African retail will lift its head and come back stronger with more tactical plans in place.
President Cyril Ramaphosa announced that South Africa will be entering an adjusted level 4 lockdown on 28 June due to a dramatic rise in cases of the Delta variant of COVID-19 infections. The lockdown is set to be in force for two weeks, but this could be extended when the government re-evaluates the situation on 11 July.
Now, you may wonder how these developments impact your investments.
The most direct casualties of the latest lockdown are businesses operating in the hospitality and entertainment sectors, as well as retailers involved in the sale of alcohol. Restaurants, cinemas, gyms, casinos, nightclubs, and museums are all under strict control and may only operate at significantly reduced capacity, if at all, during this period. Due to the labour-intensive nature of most of these companies, many people will fail to receive income during this time, and this will feed into the negative cycle of lower consumption and higher unemployment in the local economy.
However, when it comes to the JSE, the companies in these sectors represent a relatively small fraction of the market capitalisation of the South African stock universe. The majority of the earnings of South African-listed companies are generated outside the borders of South Africa because the index is dominated by multinational companies with offshore operations such as Naspers, BHP Billiton, Anglo American, and Richemont. This means that the local stock market is not an accurate representation of the domestic economy. Consequently, the earnings profile for the market as a whole is unlikely to be materially affected by this lockdown.
Another factor negating the impact of this lockdown on capital markets is that unlike the lockdowns initiated in early 2020, South Africa is currently one of only a few countries worldwide heading in this direction. According to the latest data, around half of the populations in the United States and United Kingdom have been fully vaccinated, with many more people receiving at least one shot. These countries are opening up their economies and relaxing social distancing measures as the number of active cases decline rapidly. Therefore, this is a much more isolated lockdown than the coordinated global lockdowns of the past year and a half. Again, companies with offshore earnings streams should be well-insulated against the negative effects of tightening social distancing measures in South Africa.
Autus Fund Managers has exposure to broad international markets across its suite of portfolios and is strategically underweight the South African economy. Our approach centres around careful security selection which implies that we will only include South African-facing stocks if the potential rewards outweigh the risks. Examples of these would be the limited exposure to certain South African banks and retailers in our portfolios. Some of these companies have proven their resilience in the face of macroeconomic pressure and can be bought at attractive valuations. Apart from these types of opportunities, most of our capital is deployed in companies with global earnings streams, including a portfolio of high-quality US-listed stocks.
In conclusion, the newly announced adjusted level 4 lockdown in South Africa will substantially affect only a relatively small proportion of investments available to South African investors. The unit trusts managed by Autus Fund Managers are well-placed to benefit from the global reopening and economic recovery despite setbacks in the domestic economy.
Written by Francois Roux, CFA® – Portfolio Manager – Autus Fund Managers