Is China’s crackdown unique? Investors might be surprised to look at the US

There are parallels between China’s crackdown on its education and tech industries and similar moves in the US. China investors can learn from this, says Pendal’s Samir Mehta

• July was challenging for investors in Asia and emerging markets
• But there are underlying principles to consider with China’s regulatory crackdown
• Well-managed and resilient businesses adapt and find means to thrive in any situation
• Find out about Pendal Asian Share Fund

CHINA’S recent diktat to private tutors effectively crippled the sector. Ordered to become “non-profit”, desist from raising capital, and shun foreign teachers, the sector became uninvestible overnight.

Several commentators were furious and accused the government of hurting foreign investors.

But was this behavior unique?

A blunt clampdown might be. But what about the underlying principle?

Take a look at the US to witness the state of finances for students and universities.

Over the past decade, one of the single biggest sleeves of debt that has spiralled out of control relates to student debt. There is clamor (mostly from the left) for writing that debt off.

Many politicians demand free education at community colleges. It just goes to buttress the point that in every human activity, there are multiple stakeholders.

In China, 92% of parents enroll their children in extracurricular classes and half of families spend more than 10,000 yuan ($1,500) each year on such classes, according to a survey reported by Chinese news source Caixin.

“The term often used to describe this situation in China’s education is ‘neijuan’ or involution, which literally means, ‘inside rolling’, a process of incessant competition from which no one benefits,” Caixin reports.

“Chinese parents feel intense pressure to provide the best resources to their children, who in turn must work extra hard to keep up in an educational rat race.”

On Zhihu, a Chinese social website for questions and answers (similar to Quora), almost all comments from parents are against the government’s new regulation of cram schools.

“This is like America’s Prohibition Act. You can ban alcohol, sure, but does that mean that people don’t want alcohol anymore?” posted one commentator.

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“Same with banning cram schools. If you close them, does that mean parents do not want to send their kids to these
schools? The demand is still there. It’s just becoming more costly.”

Another posted: “Only half the students graduating from Grade 9 are allowed to go to high schools. The other half have to go to vocational schools. There is a quota now. But what parents want their children to become blue-collar workers?

They’ll do everything possible to make sure their kids score well enough to be the top half.”

Unfortunately, the ban on these education companies does not solve a real problem for parents who want their children to get supplemental education.

In effect, those who can afford to pay will hire personal tutors while the State will pressure existing schools
to provide alternatives, which might be sub-par.

There are no perfect answers. Fair access to quality education at an affordable price are universal problems for almost every society.

Each society has their ways of dealing with pressures from stakeholders.

The one lesson I take away from this episode is that when one stakeholder ‘extracts’ disproportionate benefits, the backlash will be felt over time.

Contractors vs employees

Consider the admonition and regulations dished out by the Chinese authorities to food delivery firm Meituan Dianping on providing fair wages and benefits to its delivery riders.

A stock we own, it suffered a sharp sell-off on news of further tightening of regulations. The authorities had three choices when it came to imposing better pay conditions:

1. Low coverage proposal: classify all the workers under a contractual relationship instead of a labor relationship –
   meaning they are not staff of the company. Companies do not provide social benefits but shift the burden to the individual or the State.
   
2. High coverage proposal: classify all the workers under a labor relationship, meaning full coverage would be provided by the company. This would add significant costs to platforms such as Meituan which would potentially also be passed on to consumers.
   
3. Middle coverage proposal: Only a very small group of workers are classified under contractual or labor relationships.

The majority would be classified under some middle form of labour.

The only insurance that the platforms are required to provide for these workers is occupational injury insurance. The rest are up to the workers themselves to fund.

From what I gather, authorities have agreed upon the middle path, greatly reducing the uncertainty on compensation for labour.

Over time, this might still be subject to change if societal pressures force a rethink. As of now, the cost increase for the platforms will be only a few cents per order.

In my view, that burden is bearable – it will reduce profitability in the near term but not structurally damage
the business.

Markets ignore the bigger and more relevant case for continuing to own the stock. This service is crucial for society –
imagine life without the ability to order food during this pandemic.

Restaurants and delivery riders have fair demands but the platform delivers an essential service. Besides, after stringent regulatory requirements, in my opinion, no startups are likely to raise capital to challenge Meituan’s dominance.

During the worst of the sell down, I added to our holdings.

Contrast this to the US.

In January last year California passed a law Assembly Bill 5 which is supposed to make it harder for companies to hire workers as contractors.

As NPR reported at the time: “Supporters of Assembly Bill 5 say companies have been exploiting contract workers for years because they are not considered employees who get benefits like health coverage and workers’ compensation.

“The law touches many industries, from trucking to tech to certain medical professions. AB5 does include carve outs for professions such as dentists and attorneys.”

California voters later handed Uber and Lyft a big victory when they approved a measure allowing the ride-hailing companies to keep classifying their drivers as independent contractors.

If you are a steward of capital adhering to the principles of Environmental, Social and Governance factors, which of these outcomes is preferable?

China equities: What can go right?

July was challenging for investors in Asia and Emerging markets.

Thankfully, our fund was positioned to shield us from the worst of outcomes. The sell-off was furious and sometimes indiscriminate.

Some clients questioned “should we even bother investing in China?” To which my answer is a resounding yes.

We now have to ask the question – what can go right? If you reflect back to 2015 and 2018, we had sharp sell-offs across Chinese equities in both years.

Once we got past them, what mattered is what still matters today – liquidity, earnings progression and valuations.

In my view, the regulatory risks in China always existed; it’s just that we are now more attuned to them. That should not be an excuse for revulsion.

I am running screens to identify the businesses we can own over the next two to three years or longer.

The timing of recovery in stock prices is difficult to predict. Risks abound. Yet after this sell down and the growing distaste for Chinese equities, I am setting myself up to buy into stocks at much better valuations.

As always, time will tell.

About Samir Mehta and Pendal Asian Share Fund

Samir manages Penda’s Asian Share Fund, an actively managed portfolio of Asian shares excluding Japan and Australia. Samir is a senior fund manager at UK-based J O Hambro, which is part of Pendal Group.

Pendal Asian Share Fund aims to provide a return (before fees, costs and taxes) that exceeds the MSCI AC Asia ex Japan (Standard) Index (Net Dividends) in AUD over the medium-to-long term.

Find out about Pendal Asian Share Fund

About Pendal Group

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

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