Will Policy Risk Continue to Weigh on China Tech?
#Market Strategy — 30.07.2021

Will Policy Risk Continue to Weigh on China Tech?

Hong Kong China Equity Perspectives, August 2021

Timothy Fung, Head of Equity Advisory, Asia

SUMMARY

The Hong Kong/ China stock markets have seen massive sell off in late July 2021 as a result of an introduction of a tougher-than-expected nationwide, all-rounded policy tightening campaign. Sentiment on China stocks have turned extremely weak, with news of almost-continuous crackdown from various top Chinese government bodies on different sectors hitting headlines every day, which has triggered concerns on stricter regulation.

A spike in China equity risk premium - All these concerns are reflected in foreign investor appetite, as indicated by the third highest net outflows from China onshore investors and consecutive weeks of net-sell by the foreign investors. This is not unexpected as investors start to price in a much higher risk premium in their valuation models, which may lead to a long-term structural valuation downgrade on the China stocks. In particular, China tech has been a crowded trade in the past few years. A reversal of this trade recently has hence triggered a fast and massive sell-off in China tech, similar to the one witness in US tech in Q1 2020. 

China EducationThe worst case becomes reality - We do not recommend to bottom fish after-school tutoring (AST) stocks now due to the strong policy headwind ahead. We see stressed valuation with their rich cash on hand. Some analysts also expect the AST companies to spin off their AST assets as part of the restructuring plan. However, since there is no plan (yet) to return cash to existing shareholders, these stocks can still trade below cash value. It will be a painful long road ahead for AST companies.

China Internet - More headwind in 2H - We believe data security and privacy related regulations will be tightened further in 2H21 which is likely to have certain impact on business practices, internet companies’ ability to monetise their user base, and profitability, but their business models and growth trajectory should not be affected significantly as a result. Although the near-term market sentiment and fund flow remains unfavorable, we maintain our overall long-term positive view on the China Internet sector due to its exposure to the China consumer story at a time when the economy is rebalancing away from investments, more affordable valuations and, for the longer term, a lower probability of regulatory shocks.

HSTECH Index bear case of 5,500-6,000 - Gains of the Hang Seng Tech (HSTECH) Index has been wiped out after its one-year anniversary. With the 21% correction on the Hang Seng Tech Index in July 2021 as of 28 July, we expect our bear case of 5500-6000 will likely pan out. Hence, we do not see an immediate need to add on to existing exposure; and highly leveraged investors should also consider deleveraging. 

Over the next 6 months, we also advise investors to be selective, with a focus on stocks with earnings and valuation support.  

The Hong Kong/ China stock markets have seen massive sell off in late July 2021 as a result of an introduction of a tougher-than-expected nationwide, all-rounded policy tightening campaign. Sentiment on China stocks have turned extremely weak, with news of almost-continuous crackdown from various top Chinese government bodies on different sectors hitting headlines every day, which has triggered concerns on stricter regulation.

To name a few – private schools are required to turn into non-profit organisations in the education sector with no new IPO listing and foreign investors allowed; in the internet sector, Beijing readies a new nationwide campaign to clampdown on misconducts like monopoly, breaching data security and infringing rights; for the delivery platforms, there is also a jointly issued regulatory guideline on labour rights protection, which covers the food delivery platforms and ride-hailing drivers; Chinese property management sector also saw selling pressure after regulator vows crackdown on violations such as improper collection of management fee; Health tech sector sunk on fear of potential regulatory tightening, even though it has not yet been announced. 

A spike in China equity risk premium

All these are reflected in foreign investor appetite in Hong Kong/China stocks, as indicated by the third highest net outflows from China onshore investors since the Stock Connect Scheme was established. Likewise, foreign investors are also net-sellers of HK-listed China stocks for a number of consecutive weeks (Chart 1).

This is not unexpected as investors start to price in a much higher risk premium in their valuation models, resulting from higher policy risk landscape. This may lead to a long-term structural valuation downgrade on the China stocks. In particular, China tech has been a crowded trade, both by the retail and institutional investors, in the past few years.

A reversal of this trade recently has hence triggered a fast and massive sell-off in China tech, similar to the one witnessed in the US tech in Q1 2020.  

Read  HK China Equity Perspectives July, 2021:  Time to Revisit China Tech 

china net money outflow

In the following section, we will share our latest view on the two most negatively affected sectors - education and internet.

China Education – The worst case becomes reality

The State Council issued a statement on further alleviating the burden of homework and after-school tutoring for students in compulsory education (“The Opinions”) on 24 July 2021. The key policy intention is to separate the connection between capital market and academic tutoring institutions. This is to ensure private capital has low interest in reviving the business in other formats after a period of intensified ruling and implementation of new regulations.

Under The Opinions, the key market surprises are:

i) All academic K9 tutoring institutions must register as non-profit institutions;

ii) Foreign companies cannot invest in academic tutoring institutions, including those which have a VIE (Variable Interest Entity) structure; and

iii) Academic tutoring institutions that target high school students should refer to the rules for after-school tutoring (AST) in the compulsory education stage.

Last but not least, the policy also confirms other comprehensive rules to restrict AST:

i) Academic tutoring is banned on weekdays and holidays for kindergarten-to-grade nine (K9) students;

ii) The government will not approve new licenses for academic tutoring institutions;

iii) All the online AST institutions must re-apply for licenses;

iv) The IPO of academic K12 tutoring institutions is forbidden; and

v) All online and offline tutoring for pre-school students is prohibited. 

How will AST companies react?

We do not recommend to bottom fish AST stocks now due to the strong policy headwind ahead. We see stressed valuation with their rich cash on hand. Some analysts expect the AST companies to spin off their AST assets as part of the restructuring plan to revive the company and to be compliant with the latest guideline. However, since there is no plan to return cash to existing shareholders (e.g. via special dividend) yet, these stocks can still trade below cash value in our opinion. It will be a painful long road ahead for AST companies.

Vocational education is still our preferred pick

On one hand, as it could take time for the market sentiment to improve, we generally would suggest investors to switch out from education to other sector(s). On the other hand, vocational education is still our preferred pick within the education sector, given their relatively low policy risk, high earnings visibility and strong execution. After the introduction of the new regulation on AST, we believe the Chinese government may rely more on private capital in vocational education as its fiscal spending will be more focused on K12 going forward.  

China Internet - Data Security and Data Privacy will face more headwind in 2H

We mentioned previously that regulatory development in terms of regulatory tightening around fintech and anti-trust is already quite well digested by the market, with most of the uncertainties coming from the new front of investigations focusing on data security and user data privacy. We believe data security and privacy related regulations will be tightened further in 2H21 which is likely to have certain impact on business practices, internet companies’ ability to monetise their user base, and profitability, but their business models and growth trajectory should not be affected significantly. 

We also note that not all regulatory news flow has been negative in the past weeks. For example, acquisition of a search engine by a leading internet giant was approved by the Chinese government; and the Nikkei had an interview with a director from a leading fintech company, expecting its listing resumption being a prospect in the near future.

Although the near-term market sentiment and fund flow remains unfavorable, we maintain our overall long-term positive view on the China Internet sector due to its exposure to the China consumer story at a time when the economy is rebalancing away from investments, more affordable valuations and, for the longer term, a lower probability of regulatory shocks.

hstech index

CONCLUSION

Gains of the Hang Seng Tech (HSTECH) Index has been wiped out after its one-year anniversary (Chart 2). With the 21% correction on the Hang Seng Tech Index in July 2021 as of 28 July, we expect our bear case of 5500-6000 will likely pan out. Hence, we do not see an immediate need to add on to existing exposure; and highly leveraged investors should also consider deleveraging. Over the next 6 months, we also advise investors to be selective, with a focus on stocks with earnings and valuation support.