#5 WHATEVER IT TAKES (WITH CHINESE CHARACTERISTICS)
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#5 WHATEVER IT TAKES (WITH CHINESE CHARACTERISTICS)
China tech offers tremendous growth at deep value. Careful though, if not a falling knife it definitely is a sharp object plummeting
Rare opportunity to acquire cash-rich, profitable, long-term double-digit growth companies at deep value
Perfect storm of regulation, macro, geopolitics and COVID has relentlessly battered China’s technology / internet names, creating an attractive entry point often >70% below cycle peaks
Asymmetric risk-return as the bottom seems in—downside scenario seems largely priced in and already-apparent catalysts and improving drivers offer strong re-rating potential
“Recession narrative no longer out of consensus—after recent market action a considerable bounce may be due.”
Read more: #4 THESE MARKETS ARE NIHILISTS, DONNY
Since I last posted, the S&P ($SPX) has rebounded ~5% on the back of the “pause narrative” and other factors also discussed in the piece. While many of those persist today, the current rally seems to be running out of steam.
We have a huge options expiration week coming up in two weeks time—commencing on Wednesday 15th ($VIX options contract expiration) and followed by Friday 17th (huge expirations in the main index-ETFs, $SPX / $SPY / $QQQ). These coincide with the very important May Fed meeting (FOMC) on Wednesday.
Options expiration (OpEx) events are market moving and considering the size and the competing, fundamental narratives, fireworks could be scheduled to start as early as the back half of this week.
I’ll try my best to discuss market architecture and summarize how these things work in time for the big event week.
Today though, I will talk about one of my strategic (long-term) investments that I’ve mentioned in previous notes.
As many of you know, I’m long China tech / internet equities. In this two-part piece I’ll briefly explain the “perfect storm”—regulation, macro, geopolitics and COVID—that drove the market here and how it’s evolving, dissect the merits of the current investment thesis and offer my best take on how to play it.
Let’s jump right in!
Growth at deep value
Not long ago, China boasted the second largest, most liquid / deepest equity market in the world. China’s “New Economy” names (i.e., technology and internet) were some of the most prized portfolio investments for its perennially strong growth and transformational data monetization potential.
Fast forward a year and a half and questions abound regarding its “investability”.
Over $2tn in market capitalization across China’s technology / internet equity complex had been wiped out at the trough due to unprecedented regulatory tightening, heightened risk of financial decoupling from the West and substantial domestic growth headwinds. A drawdown equivalent to >10% of China’s 2021 GDP, as technology indexes corrected >70%.
The cycle lows were found toward mid-March, capped by Beijing forced intervention on the 16th after the market lost 25-30% in just a few days and 35-40% since Russia’s invasion. For reference, $KWEB—the largest China tech ETF—had three, back-to-back-to-back days of >10% losses and a ~80% decline from its peak.
Volatility reached GFC levels.
On March 16, Vice Premier Liu He channeled his inner Draghi and delivered his own “whatever it takes” speech. Lacking any specific announcement, his broad address clarifying Beijing’s stance on the property market, delisting concerns, platform company regulation and general macro policy sufficed as a “circuit breaker”.
More importantly, this speech presented a floor on valuations and swiftly boosted the market over the subsequent days. The bottom seems to be in.
Since then, macro momentum has remained healthy and continues to ease growth / “investability” fears going into H2 on the back of strengthening monetary / fiscal easing, moderating regulatory intensity / increasing regulatory clarity, stabilizing geopolitics and a somewhat more pragmatic COVID policy.
I see this as a rare opportunity to acquire cash-rich, profitable, long-term double-digit growth companies at deep value. There is truly asymmetric risk-return, as downside seems largely priced in and already-apparent catalysts offer powerful re-rating potential.
It’s been a falling knive for quite some time and many great investors have gotten burned (cough, cough, Munger!), so I will not claim to know this the price to buy these equities.
What I will do instead is explain why I own them and why I really believe this is a great entry price for long-term investors.
Regulation: Jack Ma’s Icarus moment
Very public, regulatory tightening focused on “New Economy” participants—and particularly clustered around Antitrust, FinTech / Capital Markets, Data Security, and Social Equality issued—has instilled profound “investability” fears among investors. Previous regulatory cycles created similar dynamics, but the current one is unprecedented in scope and length.
I’ll borrow a brief summary from Lillian Li—author of the blog Chinese Characteristics—that offers an idea of the ongoing crackdown:
Rather than capital, I feel like Chinese regulators never sleep. Over the past nine months, Ant Group's IPO got pulled, Community Group Buying players were fined for price dumping, Alibaba was fined for anti-monopoly violations and Meituan was also fined for anti-monopoly violations.
As part of the ongoing reforms intended to foster “common prosperity”, entire sub-sectors boasting >$100bn in market capitalization have almost ceased to exist almost overnight in the interest of “common prosperity”. The most egregious case being EdTech (Education Technology), as Beijing effectively strongarmed them into becoming non-profits.
Some people see these decisions in the context of the country’s necessity to hit their economic targets and balance a veritable demographic timebomb (interesting thread here, again Lillian Li). But it is also possible that the billionaire founders of these companies—Alibaba’s Ma has become the poster child for Xi’s crackdown—were simply turning too powerful for Chinese political leaders and thus found their “Icarus moment”.
If you’ve watched Game of Thrones, you’ll be familiar with Cercei’s walk of atonement. (If you haven’t… where the hell have you been living?!) Well… what Jack Ma & Co faced over the past almost two years certainly bears some resemblance.
In their struggle to reconcile competing priorities amid overlapping crises (i.e., novel COVID variants, property market turmoil, etc.), authorities have now repeatedly pledged to finalize reforms aimed at “platform companies” (i.e., “New Economy” / Web2) as part of a broader effort to rescue investor sentiment.
Considering the enduring market turmoil related to this latest crackdown on “New Economy” names—now broadly extended to other sectors—and a veritable founder exodus into “retirement”, regulation intensity has already moderated as the regulation cycle seems to have transitioned from its announcement phase into the implementation stage.
Macro: Bad and better
China adopted robust pandemic measures, both on the monetary and fiscal front. Yet unlike most other nations, measures were swiftly removed in early 2021 to create fiscal / monetary space and allay fears of overheating in certain parts of their economy such as the booming property market (“housing is for living not for speculation”, Xi’s words).
As a result, the macro picture turned bleak. The economy slowed down markedly, and the property / homebuilding market is undergoing a severe and highly public, delevering / restructuring process. The fact that the process has remained orderly—likely helped by a comparatively lax mark-to-market accounting methodology—does not make the situation less perilous. Vice Premier Liu He recently acknowledged as much asserting that “in certain areas, growth difficulties were even more severe than 2020”.
Now that the delevering process is well underway, China’s unique position as the only major economy easing policy in 2022 should support equity performance. Beijing began stimulating the economy on the monetary side (somewhat timidly) about 9 months, cutting a slew of lending rates and signaling further monetary accommodation.
On the fiscal side, the past weeks have seen the fast-paced adoption of a hodgepodge of fiscal actions (i.e., tax cuts, rent reductions, incremental funding for housing and financial support to trade firms).
With a 2022 GDP growth target “around 5.5%” unveiled last March and after a meager 4.8% Q1 print dragged by stringent Zero-COVID policy, authorities keep telegraphing an urgent front-loading of policy support.
Importantly, China rarely allows itself to miss its economic targets… ironically giving way for pundits to question official figures. I’ll stray off “tin hat” theories here—simply allow me to acknowledge that there may be some truth to that.
In any case, the latest economic figures (i.e., PMIs, COVID cases and lockdown indexes and early housing indicators) have started to show positive signs of inflection.
With most, if not all, economic prognosticators estimating anemic GDP figures for 2022—often wildly under the official target—the downside may already be baked into current valuations.
Up is the only way from here.
Note that the inflation issue is not an issue in China—CPI is slightly north of 2% today. As the world’s factory and with lackluster demand driven by lockdowns, they are arguably one of the main “exporters of inflation”.
As mentioned above, this is the first part of a two-part piece.
The second part will follow shortly and will touch on geopolitics and COVID as drivers of the investment thesis and offer a few of the best ways (companies and ETFs) to play this recovery!
If you have made it this far, a special thank you for reading! Feel free to share this article with anybody you think might be interested—it’s very much appreciated on my side!
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Thanks for reading,
John Galt
PS: “Bad and better” is a concept found repeatedly in Rosling’s book Factfulness. A true gem!
#5 WHATEVER IT TAKES (WITH CHINESE CHARACTERISTICS)
Thanks for sharing your thinking. Helpful to understand. Since you own China shares, it would be great if you can share names (and if you're bold your cost basis). This will really engage the community as we ride up together on wins (and down together on losses).