Emerging markets: China crackdowns underline importance of top-down investor view

China is teaching the world a portfolio construction lesson, reminding investors that geopolitical risk is an ever-present danger to valuations despite the apparent attractiveness of star stocks. Pendal’s Paul Wimborne explains  

• Geo-political risk remains an ever-present threat to portfolios
• Chinese crackdowns in tech, education a danger sign
• Investors should re-think bottom-up stock-picking approach

CHINA’s latest regulatory changes have taken some by surprise. But in a robust portfolio construction process, should geo-political risk ever be unexpected?

Geo-politics is at the top of that theoretical list of risks that investors know they need to think about, but all too often it gets overtaken by the magic of finding an exciting bottom-up investment opportunity.

Nowhere is this more evident than China, where fast-growing stockmarket darlings across sectors as diverse as education, ride-hailing and technology have suddenly seen share prices collapse due to government actions.

China’s latest regulatory changes comes as Beijing refocuses its national development goals around easing cost-of-living pressures for families and improving equality. Shares in Chinese private education companies inside and outside the country plummeted.

Should such events be unexpected?

“In the US we say, ‘don’t fight the Fed’. Well equally, you don’t fight the Chinese government – it’s a fight you are never going to win,” says Paul Wimborne, a senior fund manager for Pendal’s Global Emerging Markets Opportunities Fund.

Wimborne has long taken a different approach to emerging markets from global investing peers by starting the process with a consideration of top-down, country specific factors to determine what the investment environment looks like.

“We think there’s one specific factor that has been relevant in China: understand the direction that the Chinese government wants to take its economy – and therefore policy and regulation – and invest accordingly.

“You have to look at what the Chinese government wants to achieve and align yourself with that.”

China’s policy decisions over decades have borne this out.

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Over the past 30 years, policy decisions to drive investment into coal fired electricity production triggered various boom and bust cycles in the profitability of Utility companies. Beijing controlled both the cost of coal and the price of electricity, carefully managing the profitability of the businesses involved.

“They wanted to build more power plants and so they allowed these companies to make more money. Once they had an excess of power, the opposite was true and margins came down.”

The pattern was seen again in the technology boom of the past decade as China decided it could not allow American tech giants like Google, Facebook and Amazon to own the global internet and so allowed the creation of its own tech sector led by Alibaba, Tencent and Baidu.

This also provided the Chinese government the additional benefit of access to the vast amounts of user data that the companies had collected.  

“That led to these companies growing very fast becoming very successful and globally competitive and lots of other Chinese internet businesses emerging, in many cases funded by the giants effectively operating as quasi private equity.

“And this led to a lot of complacency among global investors, and particularly US investors where a lot of these companies were listed.

“It was felt that the Chinese internet companies don’t have emerging market risk because they are growth companies.

“But we’ve always felt that the politics could always come back and cause a problem.”

Just under a year ago, the Chinese government started to shift its policy settings, seeking a much larger oversight over the way these big tech companies operate.

Partly, this is because the tech sector is an important part of the Chinese economy.

In the US we say ‘don’t fight the Fed’. Well equally, you don’t fight the Chinese government.

Paul Wimborne, senior fund manager, Pendal Global Emerging Markets Opportunities Fund

Partly, it is because the tech companies’ successful forays into payments and finance started to threaten government banking policy, one of the key levers Beijing uses to control the economy.

But it is now also becoming evident that Beijing is in a large part reacting to negative sentiment among the Chinese people about the effect these big companies are having on society.

Long working hours, characterised by the ‘996’ work culture (9am to 9pm, 6 days a week), and low job security for gig workers like delivery drivers are starting to become topics of discontent.

Related to this discontent is the recent crackdown on companies selling tutoring services to Chinese families.

“This is a very different kind of rebalancing of societal needs that’s coming through,” says Wimborne.

“China has very low fertility rate and they’ve been trying to encourage people to have more children.

“One of the biggest complaints as to why people aren’t having children is the cost of raising children, and in particular the cost of education.

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“There’s fierce competition from parents for their children to do well in their exams, because those exams have a big say on whether they get into the right university courses and into the right jobs and there’s been a huge ramp up in the online provision of after school tutoring.

“The government has now decided that that is an unhealthy thing to happen, and that the quality of this education – because it’s geared to just passing exams – isn’t driving China in the right direction.”

News of the new policy triggered 90 per cent declines in the share prices of the top education companies, the most high-profile of which are listed on the NASDAQ.

The lesson for investors?

“Understand and align yourself to where the Chinese government wants to take its economy,” says Wimborne.

“We don’t think this makes China uninvestable and it doesn’t change how we look at China.

“These risks have always been present; they just haven’t affected the kind of high-profile sectors we are seeing now.”

About Paul Wimborne and Pendal Global Emerging Markets Opportunities Fund

Paul Wimborne is a senior portfolio managers and co-manager of Pendal’s Global Emerging Markets Opportunities Fund with James Syme.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund
 
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

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