Making Sense of China’s Regulatory Crackdowns
Recent actions against private after-school tutoring providers and ride-hailing firms have some investors questioning whether Chinese companies are investable. A more complicated picture emerges in the examination of the nuances.
Over the past year, a range of punitive regulations imposed by Chinese authorities on companies ranging from after-school tutoring providers to fintech firms has unnerved some investors and complicated China’s investment landscape.
Investors across the globe are trying to make sense of what appears to be a much stricter regulatory environment in China. The latest concerns arose after China tightened policies around the tutoring industry and when Chinese government officials visited the offices of the ride-hailing company DiDi Global on July 16 to conduct a cybersecurity review.
Both actions caused Chinese technology and other related stocks to plunge. These actions came on the heels of action last year against Ant Group, the fintech affiliate of Alibaba. In November, regulators halted Ant Group’s IPO, and this year they levied a heavy fine on the firm, as part of an anti-monopoly probe.
The increased regulation now has some investors questioning whether China is an investable market. In our view, there is not a simple “yes” or “no” answer to that question. First, it is important to remember companies in every country must deal with regulation, and the relevant regulatory environment in and of itself usually does not provide sufficient reason to not invest in a company. Regulators in other countries may have concerns about similar issues, like monopolies and consumer privacy, and Chinese regulators may simply have more power to achieve their objectives. When evaluating Chinese companies, investors may have to accept that intense regulation is a key part of “capitalism with Chinese characteristics.”
Regulatory approaches are also not uniform. We see two distinct types of regulation in China taking shape, one with manageable implications, while the other is likely to have consequences that are quite severe. Our insights on how industries may be affected appear below, after a caveat about how to view the general topic of regulation in any region.
Of course, our views come with the recognition that it is extremely difficult for anyone outside the Chinese government to know what regulatory issues it will focus on next. Investors will have to evaluate each company on a case-by-case basis, while considering what the government’s broader strategic objectives seem to be.
Keeping Regulatory Implications in Perspective
When evaluating companies and industries, we believe investors must always strive to identify and fully understand the issues that can erode the earnings power of otherwise healthy businesses. At some point in their lifecycles, most growth companies will face threats to the increased expansion of their earnings. These threats may come because of market saturation, greater competition, or increased regulation.
Some special businesses may be able to withstand these pressures longer than the average company can, but we believe these pressures are inevitable. Long-term investors need to be able to understand all these pressures, in our view, and accurately gauge their impact on the trajectory of a company’s earnings.
It is also important to remember that not all regulations are created equal. While they are generally perceived as hindering businesses, they can sometimes aid long-term growth and innovation in a market. As an example of this, the recent Chinese draft guidelines on oncology drugs could benefit developers of truly innovative, first-in-class therapies.
As noted above, many of the underlying concerns of Chinese regulators are similar to those of politicians and regulators in the United States and Europe. Big tech companies are under the microscope everywhere because of their enormous size, allegedly anti-competitive practices, control without sufficient accountability of consumer data, and their potential to create financial risk.
Again, the critical difference in China’s system of governance may be that faster action can be taken to address these concerns. Few Chinese internet firms will ever be immune from these regulatory implications, especially the firms in consumer-facing applications where scale and the network effects (whereby existing users benefit from the additions of new users) are critical to success, and thus naturally at odds with a regulator on the watch for monopolies.
Given the recent aggressive steps taken by China’s regulators, it is clear to us that regulation has become a much bigger issue for Chinese companies so it’s something investors must closely monitor and evaluate. While much of the regulators’ focus has been on the tech sector, a target that has generated attention-grabbing headlines, the scope of their efforts has included other sectors such as health care and education, particularly the after-school tutoring services.
Possible Motives for Increased Restrictions
When a regulatory environment in any country significantly changes, questions arise about the motives behind it. It may be that the Chinese government is trying to redirect where the energy, entrepreneurial spirit, and investment in the tech sector is going. The government may be looking to restrict development for consumer technology firms, which are more ad-based or entertainment-focused, with offerings such as short video and music. It may want to promote a shift to engineering-led technology firms, such as those focused on semiconductors, artificial intelligence and machine learning, and higher-end manufacturing. As Rui Ma, the venture capitalist and host of the podcast Tech Buzz China, has noted, China’s national strategy seems to be to become more of a manufacturing superpower like Germany and less of a services/financial services superpower like the United States.
It may also be that the government is looking to address the demographic problems posed by its aging population. Through regulation on certain industries, like after-school tutoring, the government may be looking to reduce how expensive it has become to have children, and thereby provide incentives for families to have more.
Manageable vs. Fatal: Two Distinct Regulatory Themes
We do not think the situation in China can be viewed as a uniform crackdown that may severely hinder all businesses’ prospects. There appear to be different “flavors” and sector focuses, with two distinct sets of implications.
1. Manageable Reforms: Antitrust measures, content regulation, curbs on big companies’ expansion
The government is cracking down on anti-competitive practices in the ecommerce, local delivery, travel, ride-hailing, and internet search businesses. Two or three main companies lead each of these segments. As a result of the government’s antitrust measures, most companies will face the annoyance of having to pay fines or curb certain practices. But the new regulations could have the unintended effect of strengthening the entrenched incumbents because they may be the only ones that can afford the higher compliance costs.
The government is also looking to more heavily regulate, and even censor, the content generated by gaming, video streaming, and social media companies. The regulators are determining what are acceptable public expressions of opinion. The parameters for this haven’t been entirely clear, as the government seems to be continually moving the goalposts.
Regulatory efforts are also underway to limit the concentration of corporate power, particularly among vast companies that already dominate a number of business categories. One way to limit them is to regulate what new sectors companies can enter. Politically compliant firms may still be allowed to launch new business lines, but only if they are competing based on an innovative technology, rather than simply using the profits from other business lines to cross-subsidize new ones and squash smaller competitors.
In our view, these types of regulations will not greatly restrict companies’ success. The affected companies will likely be able to pay their fines, adapt their practices, and continue growing.
2. Fatal Regulation: Reshaping entire industries and cracking down on scofflaws.
The fintech and for-profit education sectors face much more problematic regulatory developments. Rather than try to curb specific practices, the government seems intent on fully reshaping the acceptable scope of business for certain online firms in the fintech and after-school tutoring spaces. This creates uncertainty over whether individual company business models will even remain viable. For investors, of course, that raises serious alarms.
The consequences are also likely to be severe for companies that chose to flout any of the government’s warnings. DiDi did this. It was initially vulnerable to antitrust measures, but the company rushed ahead with its IPO, in defiance of government concerns. As a result, it is now facing severe restrictions on its business.
What Does it All Mean and How Should Investors Respond?
Tighter scrutiny and regulation await almost every major internet firm in China. In most cases, these actions will likely be incremental rather than draconian, on the premise that most companies will quickly get the message and align their practices with the government’s desires.
Companies that heed the government’s warning and “course correct” may go on to thrive in a tighter and more predictable regulatory environment, while those that ignore the signals may face a deeper crisis.
Antitrust measures, content regulations, and restrictions on expansion may result in fines, and some limits on growth, but these enforcement measures do not entirely alter the prospects for a company. Measures that would bring fundamental changes in a company’s business model, however, do change their prospects. For investors, that uncertainty may be too much.
Investors who are ready to pursue the growth opportunities in the world’s second-largest economy, but who also want to avoid the regulatory cloud over tech might consider other sectors. One possibility is consumer-sector companies where there is regulation on matters such as wages and health and safety standards, but these rules do not have the same level of implications as the new regulations affecting tech companies. Biotech also seems to be enjoying considerable government support, without significant regulatory intervention, although time will tell on that, as well.
As investors, we recognize the situation is dynamic. We are closely monitoring the potential impact of increased regulations on Chinese companies. We will adjust our portfolios accordingly when we foresee the regulatory impact becoming too burdensome.
Still, we believe China will continue to present considerable opportunities for investors, given its large number of innovative businesses and the massive addressable market for a variety of its products and services.
References to companies provided for illustrative purposes only China’s evolving regulatory focus on various industries. The companies represent examples of recent regulatory focus in China. Ant Group and DiDi Global are not held in any Sands Capital strategies. Alibaba is held in our Global Growth, Emerging Markets Growth, and International Growth strategies.
The views expressed are the opinion of Sands Capital Management and are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. The views expressed were current as of the date indicated and are subject to change. This material may contain forward-looking statements, which are subject to uncertainty and contingencies outside of Sands Capital’s control. Readers should not place undue reliance upon these forward-looking statements. There is no guarantee that Sands Capital will meet its stated goals. Past performance is not indicative of future results. The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients. There is no assurance that any securities discussed will remain in the portfolio or that securities sold have not been repurchased. You should not assume that any investment is or will be profitable. GIPS® Reports and additional disclosures for the related composites may be found at Sands Capital Annual Disclosure Presentation.