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What's happening in China?
The Red Dragon Rises
On Oct. 24 2020, Jack Ma, the man who built China's largest e-commerce company Alibaba, was addressing an annual gathering at the Bund Summit.
Bund Summit is the yearly gathering of the most influential people from Chinese industry - regulators, business leaders, billionaires - you name it.
It was to this crowd, Jack Ma was addressing in his key note address, when he went off script and decided to criticize the Chinese financial regulator (whose senior members were sitting in the front row at the summit).
He accused the regulator of stifling innovation and said the state owned banks (some of the largest in the world) suffered from a 'pawnshop mentality'.
Why did Ma decide to do this, days before the $37 Billion IPO of Ant Financial (the fintech arm of Alibaba) is a mystery, but one thing was clear, that speech was the first domino to fall for the Chinese Tech industry.
The Chinese Tech Empire is controlled by three corporations - Baidu, Alibaba and Tencent (BAT).
Between these three, it is Alibaba and Tencent that effectively have the lion's share of the Chinese startup investment world.
The below two graphics will give you an idea of just how wide and far reaching their empire is. There are maybe only a handful of tech companies in China that don't have either Alibaba or Tencent as their investor.
These two companies don't just control the industry - they are effectively King makers too. Any startup that gets the funding from either Tencent or Alibaba effectively wins the entire market share in its respective industry.
Alibaba and Tencent have over the years built their own walled gardens - links to Alipay or Alibaba owned companies do not work inside WeChat (a super app run by Tencent) and links to WePay (by Tencent) do not work with applications built by Alibaba.
Imagine if Microsoft and Apple controlled everything from Facebook to Google Pay and didn't allow their products and services to integrate with each other.
Such is the situation in China.
For years the Chinese regulator had turned a blind eye to these companies and their ambitions - the Chinese economy was growing, billion dollar start ups were being minted every day and Chinese technology companies were overtaking the western world in research, quality of products and revenue.
Until that is, on Oct 24th 2020, when Jack Ma made that speech.
Ma's speech sent alarm bells ringing across Beijing and it is believed that Xi Jinping himself culled the Ant Financial IPO.
You see China isn't your typical communist nation - you're allowed to do whatever you want to as long as you obey laws and do not go against the ruling party.
The communist party of China only hates one thing - dissent, and they do everything in their power to keep this under control.
Ma's speech was viewed as an attack against the ruling party and Beijing knew it had to put a lid to the rising power of Chinese Tech industry.
Within days after Ma's speech, the Chinese regulator launched a probe against both Tencent and Alibaba under monopolistic practices.
As part of these investigations, the regulator has come up with new laws to ensure an incident like the one faced with Ma, doesn't repeat itself.
Some of these new laws effectively puts a cap on how far and wide these companies can grow without regulators approval, some deal with cybersecurity laws, some deal with ensuring all Chinese companies that want to list abroad, do so post gaining permission and a cybersecurity clearance from the regulator - something with Didi Chuxing (the Uber of China) refused to do and in retaliation the regulator stopped the company from onboarding any new customers, days after it was listed on the New York Stock Exchange.
What's happening with these two giants and boarder Chinese Tech industry is their government finally taking anti monopolistic action against them and opening up the industry to outsiders for competition.
This is very similar to what is happening in the West and has happened before with - A&T, Standard Oil, Microsoft.
United States Congress has an open anti trust investigation against the giants there - Microsoft, Apple, Facebook, Google and Amazon.
The effect and rulings are just faster in China as its a single party system.
July 26, 2021 - Beijing unveiled new rules for Chinese private education sector.
These new rules, effectively barred the tutoring companies including EdTech firms from earning profits, raising capital or going public.
This however isn't related to the broader technology industry and to understand this, we have to travel back in time to the year 1979.
1979 was the year when China started enforcing its 'one child policy'.
Under this policy, married couples could only have a single child. There were legal repercussions including jail time and hefty fines if anyone were found to have had more than one child.
This was nothing new in China, the country has been playing with reproduction rates of its citizens since the early 1950s, limiting and controlling the birth rates of it population.
The one child policy though was the strictest reproduction related policy enforced to date. Now, if only China had consulted Hans Rosling before enforcing this, it would have realized that population dynamics adjust automatically as the country progresses.
Here is a great video of him explaining this dynamic in detail.
In 2015, after almost 4 decades of one child policy, Beijing announced that it will repeal the policy and allow everyone to have upto 2 children per couple.
The response from the citizens though was lukewarm. After decades and almost two generations of single kids who were brought up with no siblings and aged parents to look after, a lukewarm response to having kids and starting a family was the best Beijing could hope for.
Rising cost of living, every adult having to support aging parents and virtually no siblings meant that not many were interested in getting married and raising a family - most didn't know how to.
This is a problem for China today, the share of population that is aged is increasing much rapidly compared to the share of population that is young. This means that the state has to support a lot more of old aged population who do not work and generate taxes compared to the active workforce of young able bodied individuals.
This problem worsens further as the birth rate in the country is dropping below the sustained level of 2.4 new born per person who dies.
If China doesn't find a way to encourage its population to reproduce more, it will face a bleak future like Japan - whose economy rose rapidly during the 1970s only to hit a peak in 2000s as the country's population shrunk in size.
To alleviate this, the Chinese government is taking steps to ensure the cost of raising children is minimized to the least possible, in hopes that this will encourage its population to produce more kids.
Every five years, the Chinese government publishes a strategic plan - its a document that lays out its goals in excruciating detail - everything that China wants to accomplish in the next five year.
Here is the link to the latest 5 year plan.
This plan clearly lays out its ambition to increase the working urban educated population. How do you increase population? By incentivizing your citizens to reproduce more. How do you incentivize your citizens to reproduce more? By making sure the cost of raising children is minimized as much as possible.
The action against EdTech companies is a step towards that direction. Cost of Education in China is one of the highest esp. for private schools and tutors. Government wants to ensure that same level of education is available to all its citizens at affordable and subsidized rates.
This gives us a perspective that the government’s action against the Ed Tech companies isn't the same as its action against the giants - Alibaba and Tencent.
These are two different events, driven by different reasons and just happen to occur and coincide close to each other.
The occurrence of these events close to each other was enough to spook investors though. Chinese Tech stocks have taken a beaten and have lost upto $800 Billion in their market cap through last week and even more since Ma's gave his speech.
The Nasdaq Golden Dragon China Index, which tracks the Top 30 Chinese companies has fallen by almost 50% since its peak in Feb'21.
Such is the panic today when it comes to Chinese stocks.
To give you an idea of the intensity of panic, lets take a look at valuations of Alibaba and Tencent. Here is what Alibaba as a business is doing. Its a business that is growing at ~50% YoY, has yearly sales of more than $100 Billion, produces $35 Billion in Cash Flow every year from its operations. Alibaba, also includes the stake in FinTech giant Ant Financial (which we discussed at the start of this article).
What is the current market cap of BABA, you ask?
Its about ~$500 Billion. The whole business is available at about 5x Sales and less than 1x its FY24 Sales.
Let's look at Tencent.
Tencent too is growing at fast rates, has $75 Billion in sales and produces ~$30 Billion in cash flow from its operations every year.
More importantly Tencent has stakes in almost every promising gaming company in the world.
It holds IPs like Fornite and control Epic Games, the makers of Fortnite. Tencent has stake and partnership with Roblox (the US gaming Metaverse company) and Tencent owns Unreal Engine - which is arguably the most advanced gaming system ever developed.
Such a business too is available at ~$500 Billion.
There are many other similar businesses in China that have face a significant drop in their stock price over the last few months and may continue to face it for next few.
In my opinion, the panic is making these wonderful businesses available for less than they are worth - and it is in this panic a good investor finds value.
Similar panic ensued in the month of March 2020, those who were willing to take the risk and find value in panic have essentially doubled their portfolios since then, if not more. I believe what's happening to the Chinese stocks today, is similar in nature, mostly cause it has nothing to do with the fundamentals of these companies but everything to do with a temporary blimp caused by increase in regulations.
Over time these businesses will find a work around, adapt and evolve as businesses have in the past and as great businesses will in the future.
So what am I doing?
I have limited my exposure via Edelweiss Greater China Offshore Fund and buy on dips while having an active SIP. I find the fund to be very well established, its a feeder fund to the broader parent fund controlled by JP Morgan Asset Management (JPAM).
Here is their fact sheet if you're interested.
As you may observe from their holdings, the fund has exposure to semi conductor companies like TSMC and doesn't have any EdTech names under it. I personally believe in two years time, the returns on this fund will be beyond any other index globally.
Never let a good crisis go to waste and I personally believe this is as good of a crisis as any to find opportunity in.
Hope this provided some clarity in what is happening in China.
Until next time.