China Tech Crackdown Explained: Will I buy Chinese Tech Stocks after the plunge?

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Note: This Article first appeared on Patreon. Making it publicly available given the huge interest on this topic. If you found it useful – do considering supporting Financial Horse as a Patron, and get access to my personal portfolio, latest stock watch, and updated thoughts.

I’ve been getting a ton of questions about the whole China Tech crackdown and crash:

Hello FH, do share your thoughts on DiDi and China’s crackdown on US-listed, CN tech companies in general. Looking forward to hearing your analysis!

Hi FH, DIDI share price took a huge hit last Friday. Do you see value here from risk reward perspective, say in 2-3 years from now?

Hi FH, Didi has crashed to $8. Would you still continue to buy? Is the risk getting bigger with the possibility of delisting?

Is there a strong possibility that DIDI would be forced to delist ? The price point is fast becoming tempting to start a position. Appreciate any views on this.

Any thoughts on the private tutoring crackdown in China? I don’t see how the govt is gg to control this now that the industry has ballooned so much. If im a parent and my kid’s tutoring co goes out of business, im just gna find another one. Do you think there’s an opportunity to buy those dips?

 

Background: Timeline of the tech crack down

Let’s zoom out a little, and summarise the timeline to date:

Nov 2020: China pulls the Ant Financial IPO, and begins a crackdown on Ant Financial

Jan 2021: Crackdown expands to other China tech companies such as Meituan, Pinduoduo, Tencent Music etc

March 2021: Pinduoduo CEO steps down to “focus on other pursuits”

May 2021: Bytedance CEO steps down, presumably also to work on his hobbies

July 2021: Crackdown on Didi following their US IPO. Suggestions that the VIE loophole is being relooked

July 2021: China cracks down on the Edutech sector – suggestions they will make the entire sector non-profit. TAL Education closes down 70% that day.

For the record, this is the 2021 performance for some of the big China companies (apologies to non-Chinese readers):

China Tech Crash Explained

Now before we can decide if this is a good investment, we first need to understand the overarching framework.

We need to understand:

  1. Why the CCP is cracking down on China Tech
  2. Then we can start to understand the how.
  3. And only then can we understand whether it’s a good investment.

Because there’s a lot of information to digest, I will structure the rest of this article in a Q&A format.

Why is the Chinese Communist Party (CCP) cracking down on China Tech Stocks?

Investing in China is unique.

Many investors are used to Western style democracy and its systems of checks and balances.

In the US, even if Trump wants to ban Chinese companies, there’s a whole system of checks and balances that prevents him from doing so.

He needs to go through congress, and even if its approved you can challenge it in a court. The system will hold him back.

In China, the word of the Chinese Communist Party (CCP) is supreme.

You need to think of it like ancient China, where the Emperor’s edict is the law of the land. If the Emperor wants something done, the only question you ask is how do you want it done. You never ask whether it’s the correct decision.

And in China, the CCP makes decisions based on what they think is in the best interests of China. If they think that getting rid of Alibaba is in the interests of China, Alibaba is as good as gone.

No checks and balances here. It’s a top down system where the nation is king (China) vs a bottom up system where the individual is king (US).

These are the ground rules, and if you’re not comfortable with these risks, you shouldn’t be investing in China.

This part of China will not change.

It’s like expecting the US to give up their freedoms. Never happening.

What is the rationale behind this Tech Crackdown?

Now this is just my opinion based on what I’ve read in Chinese media, from prominent Chinese commentators, and from my time in China.

Protip: Ignore most of the western media when it comes to China. If you’ve never lived in China, you can never hope to understand how it works. You need to look at China through the lens of China.

With that out of the way, this is my view on the 2 overarching objectives behind the CCP’s current regulatory crackdown.

Namely, that Tech Companies must comply with 2 rules:

  1. Rule 1 – Comply with national strategic objectives
  2. Rule 2 – Sustainable competition (no anti-competitive practices)

What is Rule 1 – Comply with national strategic objectives?

Remember how the CCP makes decisions based on what they think is in China’s best interests?

Well, this is what they think is in China best interests:

  • Solve the demographic crisis – China has an ageing population, they need to raise the birth rate
  • Stable economic growth – Economic growth must be stable. CCP wants to avoid a repeat of Japan in the 1990s and their lost decade.
  • Reduce inequality – The inequality gap between the rich and the poor cannot be too big, because in China’s history that has almost always resulted in revolution.
  • Keep manufacturing onshore and upgrade domestic capabilities – This is a subset of the stable economic growth point
  • Data Security of China consumers – If you store data on Chinese consumers, it must be stored in China and used “ethically”

If you’re a tech company in China, everything you do needs to be in line with these goals above.

To give an example – the “sin” that Ant Financial committed, was that they extended loans without having to hold capital on their balance sheet (they farmed it out to a state bank). 

In other words, if the loan defaulted, Alibaba would not suffer as a financial loss, because the ultimate owner of the loan is the bank.

This meant Alibaba had no “skin in the game” – they were paid for making the loan, but suffered little downside if the loan went bad. This misalignment of interests could have created unsustainable debt growth like that in the West leading up to 2008.

So the entire system had to be revamped, like we saw with Ant.

What is Rule 2 – Sustainable competition?

Very simply:

You can compete and win if you deliver real tangible benefits to consumers. But if you compete and win by creating an artificial monopoly, the regulators will come after you.

Creating an artificial monopoly using (1) money (capital) or (2) anti-competitive practices is not allowed.

If you ask suppliers to list only on your platform, and kick out all sellers who don’t comply, that’s unfair competition (Alibaba).

If you negotiate a distribution contract for music, that prevents any other player in China from buying the same music, that’s unfair competition (Tencent Music Entertainment).

If you give out a ton of subsidies to gain market share, driving out your competitors, and then raise prices at the end, that’s unfair competition (Pinduoduo, Alibaba).

If you build such a great product that consumers buy your products without you pulling dirty tricks, that’s fair competition (Huawei, Xiaomi, DJI… maybe).

How are the Rules implemented?

So that’s what China wants to achieve.

Then we go to the how.

Edutech broke both Rules 1 and 2 so they got absolutely massacred.

Ant Financial broke both as well, so they got a harsh treatment.

Didi broke Rule 1, so they were hit, but not as bad as Edutech/Ant.

Tencent Music broke Rule 2, so they were hit, but not as bad as Edutech/Ant

You get the idea.

So FH… what happens next?

If I am right, then the crack down will continue to play out.

What started with Ant in 2020, will continue to play out for much of 2021 (and some of 2022).

The Chinese regulators will continue to roll out rules and guidelines for the tech industry.

This was what I wrote a couple weeks back, and I still stand by it:

I think it’s part of a broader move to regulate China tech more heavily…

If I am right, then the days of freewheeling China tech are over. And we’re moving into a phase where tech is more closely regulated in China, which will hit margins and growth.

Margins and growth will have to come down in the short term as this regulatory crack down plays out, which will hit valuations.

Cathie Wood has been selling China tech stocks on fears of a “valuation reset” for Chinese tech, and I don’t disagree.

Am I still a buyer of Chinese Tech Stocks?

Yes, but you need to understand that my timeframe is long term.

And when I mean long term I mean 3 – 5 years, possibly 5 – 10 years.

Short term, there’s going to be a lot of volatility.

But longer term, 2 of the secular themes I am very bullish on are China, and Technology.

Both will change the world.

And as a long term investor, I am happy to allocate accordingly.

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Specific Questions on China Tech Stocks

Now that’s the broad, overarching framework I’ve been using to approach the China Tech crack down.

Agree or disagree, just leave a comment below.

And now I move onto the more specific questions, using my framework above.

Would I buy the dip in China Education?

No, I think it’s too early to call this one.

I think the dip buyers are underestimating the education issue from a China policy perspective.

The background here is that the education system in China is hyper stressful. If you think the Singaporean education system is bad, wait till you see China.

The kids there study from 7am to 10pm every day for most of their childhood. After school tuition is viewed as mandatory. The kids that get to go to Tsinghua are Number one from their province, with 80 million people.

Still think getting into RI is hard?

And then when COVID happened, the Edutech players swooped in with a business model based on fear. It was – either you sign up for this package for your child, or we teach your child’s competitor.

I mean that’s just plain mean.

The current after-school education system (tuition) is too expensive. It (1) raises the cost of raising a child, and (2) causes a lot of stress for the child and parent.

If parents think raising a child is too expensive and stressful, they won’t have children. One of the major goals for the CCP is to raise the birth rate, so Education is a big problem that needs to be solved.

If you need to crush a $6 billion company listed in the US (TAL Education) to solve this problem, consider it done.

I think for education, we need to understand the longer term vision for private education in China.

Making it non-profit is not entirely impossible here.

Will Didi get delisted?

Genuinely don’t know.

But based on the analysis above, Didi’s “sin” isn’t as bad as Edutech or Ant.

They’re just a bit loose with their personal data.

If they can take steps to safeguard user data, they should be fine.

Is Risk-Reward for Didi good at this price?

At current price of $8.06, Didi’s market cap is $38 billion. That’s cheaper than Grab, which will list at $40 billion.

At the same price, would you rather (1) buy a monopoly ride hailing player in China, or (2) a ride hailing / food delivery platform operator in South East Asia?

Don’t forget that most of South East Asia is in rural Malaysia or Indonesia, where purchasing power is very low.

I like Didi, but I will probably average in to spread out the risk.

It’s definitely a risky investment though, so don’t buy if you’re not comfortable with losing your capital.

If you want risk free go with SSBs at 1.5%.

What is the broader impact for China Tech?

If it wasn’t obvious to the other China tech CEOs, I think it is now: Lie low for the whole year please.

CEOs for Bytedance and Pinduoduo have already stepped down. Jack Ma has stayed out of the limelight for a year.

Now is not the time to be making an aggressive push for market share with shady tactics.

Just lie low, and bide your time.

Closing Thoughts

As a long term investor, I think the regulatory clampdown is short term negative, but long term positive.

A lot of these changes will foster a more sustainable and healthy environment for China tech to grow in the years to come. It gets rid of the unsustainable practices, and paves the road for tech companies to contribute positively to China’s development. But it will create a lot of problems in the short term.

Zooming out, I think the runway ahead for China tech is just massive, and one that I’m happy to participate in.

If you’re interested, you can check out my full portfolio and watchlist of China stocks on Patreon. I update it weekly for stocks I buy and sell. 

But some caution is warranted. The crackdown will take some time to play out, so averaging in just makes a lot of sense here. 

Play the long game.

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23 COMMENTS

  1. I am a Chinese internet veteran from China, now residing in SG so I guess my comment is somehow legitimate. Overall your comments remind me of a famous words from Jiang Zemin, the former President of China, he told some HK reporters ” you are young and simple, sometimes naive”, he used mandarin for the entire sentence but used English word Naive specifically. Basically FH represents a big group of foreigners who generally looking at China from positive or progressive perspective, I think it’s partly because they never lived in a nation of totalitarian regime (living in China for a few years doesn’t mean you can truly feel it), so they couldn’t understand the magnitude of evilness of politicians, in particular the supreme leader. The whole story to crackdown tech industry doesn’t necessarily to be interpreted from goodness like FH did, it can be explained from way lower motivations. But that’s a long story, not suitable for this dialogue. All in all, if u really want to bet Chinese tech companies’ upside, control your allocation and tell yourself this is an ultra high risk investment

    • Hi Samuel, thanks for the amazing insight, and I really appreciate it. As a Chinese Internet Veteran, you will be much more familiar with China than I can ever hope to be, and you’ve given me a lot to think about.

      I concede that I could have gotten my analysis completely wrong. And indeed, it could be as you suggest.

      My question then:

      (1) How do we know which interpretation is correct? How do we test / gather information to confirm which is right?
      (2) If your view is correct, what is the difference in the long term implication to tech stocks. Does it mean that they are not a good long term investment?

      • Hi, FH, happy to share my two cents. Basically you need to read XI’s numerous speeches over the last decade (in Chinese, lots of core msg lost during tranlation), to truly understand what he is thinking about. His thought basically has no difference from many ancient emperors and you know not all emperors were making decision for the goodness of his kingdom, at least from retro perspective, history told us the motivation can be very emotional or subjective or misguided. Anyway, investing in China is indeed tough, u need to balance your greedy to earn more return and bear intrinsic risks associated with this market. It’s a tough call for everyone and at the end it’s a judgemental call. At least u should make an informed decision, not blinded.

    • Hi Samuel, thanks for the amazing insight, and I really appreciate it. As a Chinese Internet Veteran, you will be much more familiar with China than I can ever hope to be, and you’ve give me a lot to think about.

      I concede that I could have gotten my analysis completely wrong. And indeed, it could be as you suggest.

      My question then:

      (1) How do we know which interpretation is correct? How do we test / gather information to confirm which is righ?
      (2) If your view is correct, what is the difference in the long term implication to tech stocks. Does it mean that they are not a good long term investment?

      • BTW, CCP, from my perspective, remains a revolutionary political entity rather than a normal progressive party. And what’s revolution? it’s by definition, violent and represents a radical social structure change in the form one group of ppl overturns the other group of ppl by force.

        • Thanks Samuel – really appreciate your thoughts and sharing. You’ve given me much to think about, and perhaps I was indeed underestimating human selfishness.

          Will do my best to incorporate this thinking and see if I can share updated views over the weekend.

          Cheers. 🙂

  2. Hi FH, thank you for the interesting post. I do agree with certain points in the post and see those big tech companies as bullish in the years to come.

    I do believe that all investors/readers will have their own perspective on what’s happening in China now hence there will always be people willing to bet against them or with them and that’s the beauty of the stock market. Its about making the right calls.

    While the removal of anti monopoly practices may hurt market in the short term, I do believe that these companies will be forced into a more competitive mind set rather then solely rely on monopolistic practices as people tend to get “lazy” if there is no competition and if they truly have the brightest mind leading them, it won’t be long before they innovate themselves or come out with new products and services to remain in the top of their field. People don’t just buy into a company base on its business but the vision of their leaders as well.

    Noted you have previously done some articles on these companies and the consumers using their services and most people seem to overlook the consumer behavior/psychology portion. I just don’t see them losing hundreds of millions of consumers to their services just because of what is happening on the regulatory front. The average consumer will not understand how these may even affect them. Perhaps services may slightly get cheaper and more options available but how will consumer behavior/psychology play into the regulatory changes? Will they decide to explore more available options or likely stick to well know brand names?

    It will be interesting if you could do some articles on their next in line competition as well to see how these regulations may benefits their competition and the different between services/goods offered and whether it may cause consumers to look elsewhere now that more options are available to the consumers.

    “Know Thy enemy and know thy self” – Art of War

    There also the ‘aftermath” of regulatory crackdown which most people don’t look into. How will these companies set forth their road to recovery with its relations with CCP and their fundamental businesses.

    • Hi Jackel,

      Thanks, and that’s a very interesting perspective. Appreciate your sharing.

      Let me mull over this one. Given the way things are playing out, I’ll probably do a follow up post on China tech this weekend to share updated views. 🙂

  3. Hi FH,

    Any thoughts on healthcare tech stocks, e.g. JD Health, PA Good Doctor? These are plummeting too, especially JD Health, although there doesn’t seem to be any press about regulators coming after the industry specifically. Perhaps there is intense fear that they will be next in the crosshairs?

    Would be interested to hear your thoughts. Cheers.

    • I think each industry needs to be analysed individually based on the principles I shared in my article. It’s not so straightforward, and investors are taking a sell first and ask questions later approach.

      Will share updated views this weekend once I have some time to digest my thoughts. 🙂

  4. Dear FH,

    Thanks again for your timely article. Much appreciate.

    If I am not keen to buy into a specific China stock Or China Tech stock. Is there some kinda of ETF that cover China stock OR China Tech stock that i can buy instead? Thought it might be slightly safer & of cos the profit will not be as great as putting a big bet on a specific China Tech stock and get it right.

  5. Hi,

    I like your overview of the China Tech.
    One other area that concerns me if the constitutes of the ETF.
    Do you think there is too much weight age on e-commerce related companies? These companies does not really has valuable assets to back their share prices.
    Also these companies are too heavily reliant on domestic market… Do you think they will recover with so much clamping down of their business?

    • Yes – I agree those are all valid concerns.

      The problem is that the Chinese economy is not as developed as the US. There is no S&P500 equivalent, because most of the best companies may not even be public yet.

      We need to take things as they are, and today, most of the biggest players in China are ecommerce/tech/domestic in nature. There’s really not much option frankly.

      The answer will change in 5 years, but as at today, this is how the market is structured.

  6. Hi AAA,
    There are many, e.g:
    CSOP Hang Seng TECH Index ETF HKD, HKG: 3033
    iShares Hang Seng TECH ETF HKD,HKG: 3067
    Lion-OCBC Securities Hang Seng Tech ETF (HST.SI)
    David

  7. Hi FH, this is my first time reading your post. No one can predict the future, like you said, your comments are based on current situation and any investors should know what level of risk they can take. The recent tech stocks meltdown by CCP was timely as the young CEOs behaving cocky. China is a very big market and still young unlike the west which are matured and they become so valuable is due to China cheap labour and supply chain over the past 20 years. China now is no longer a cheap labour source but still competitive as people are upgrading their skills and educated. The government have to take care of 1.4B people which is not an easy task. They have to be authoritarian to rule. The western freedom of speech will create a big social problem, imaging letting 1B having their freedom of speech. Our backyard already proves that authoritarian rule just for a fraction of the China population have worked. Thank you for your patience.

    • Hi Lawrence,

      Welcome to Financial Horse!

      Good comment – I agree with you. It’s easy for foreigners to criticise Beijing and the methods, but when you’re ruling a country that vast, there are certain actions you will inevitably be forced into.

  8. Hi Financial Horse,

    Thanks for the article.

    I am personally in the tech sector. The underlying of your argument is that China will continue to make technology advancement in the years ahead after the crackdown. Now there are a few factors that’s unique to tech sector:

    1) Technology typically advances by a small group of highly talented people who are given liberty to pursue their interests despite massive uncertainties in the future. Most of the targetted companies fall under this category. IMO western liberal system is the best system for tech to advance as it is built to reward those who are willing to take the most risks.

    2) Technology typically advances by innovative young people. Now that you have a central leadership comprising of old people making decision on what’s allowed and not allowed to be worked on, what’s the likelihood of these old people making the wrong decision? And if that happens, it quite likely that the Chinese will fall behind in technology advancement as technology typically advance very fast.

    3) Highly talented people typically are well educated and are not short of options globally. The introduction of such policies essentially mean that there is a limit on how far you can grow your company. Does such act skew the risk-rewards to this group of people to move elsewhere and resulted in a net loss to China?

    Of course, I agree that China is a closed system and even if it falls behind in terms of technology advancement, it will still enrich another group of people who are obedient. What this means is that our bets should be on the group of people who are obedient. I am just not sure if the Chinese drop in its technology competitiveness globally, whether we should set a long investment horizon in the sector.

  9. Dear FH, thank you for pointing me back to the article you wrote earlier this year. I appreciate it.

    There is something I do not quite understand about some ETF. Some ETF say they will payout dividend however, some ETF state down clearly that they do not intent to payout any dividend they collect from the underlying stock. They will instead use the dividend to reinvest. Can I ask for ETF that decide to reinvest the dividend they receive, how does this action benefit those who invest in their ETF?

    Sorry for asking a newbiz question.

    Thank you

    • No worries!

      It’s mainly for dividend withholding tax. In some countries (eg. US -> Singapore), there is withholding tax on dividends (30%).

      So instead of paying out the dividend, it’s more efficient from a tax perspective to use an accumulating ETF, where the ETF will reinvest dividends instead of paying it out and incurring withholding tax.

  10. Hi Horsey
    Could you share your thoughts on the newly launched Lion- OSPL L S$ ETF? Do you think its a good way to invest in the long term growth of China using a dollar cost averaging policy like say investing a fixed amount of money in this ETF which hold 80 of China;s largest companies in the A and H markets? Thx

    • I think it’s alright, gives you pretty broad based exposure to China.

      Management fee at 0.45% is on the high side, but that’s the case for most ETFs with exposure to A shares.

      Biggest concern would be liquidity – knowing the SGX, most of these ETFs have very poor daily trading liquidity. I would give it a month or two to settle down and see what liquidity looks like, before I open a big position (if it were me).

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