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When Restrictive Policies Collide With Solid Fundamentals

Policy changes can have a major impact on a company’s long-term fundamental outlook and equity valuation. In 2020, it became evident to us that China’s tightening regulatory environment would have significant investment implications after the Chinese Communist Party (CCP) introduced new policies that began to dampen the growth prospects for some of the country’s most profitable and fastest growing tech companies—the same companies that had been the locomotive of the market's progress for many years.

Government intervention moved up a gear when the CCP suspended Ant Financial’s IPO in the fourth quarter of 2020, which at the time was expected to be the largest on record. In our view, this suspension was a clear signal that the investment environment for China’s large internet and e-commerce companies could be permanently altered.

In 2021, the CCP targeted other industries, as the government focused on reducing social inequalities, a concept it referred to as “common prosperity.” In this pursuit, the Chinese government identified sectors of the economy that it deemed to have levied an undue burden on the average Chinese citizen. Nearly all sectors of the Chinese economy were affected, with property, education, and healthcare drawing the most scrutiny. In response to the CCP’s policies, we took decisive action in our emerging markets portfolios to significantly lower exposure to Chinese companies, especially in the healthcare and internet segments.

 

The CCP Doubles Down

Leading up to the National Congress, Chinese authorities indicated that their focus had shifted towards promoting greater economic stability and more market-friendly policies. Many market participants hoped this would form a constructive, and even a supportive, backdrop for the equity market. However, President Xi Jinping recently reasserted his policies, and we see signs that China will become even more restrictive for the private sector. Significantly fewer corporate executives were invited to the National Congress compared with previous years. Importantly, President Xi announced no changes to his zero-COVID policy and reinforced the themes of "common prosperity.” 

Where We See Opportunities for Growth

We were significantly underweight¹ China in 2021, and we continue to maintain this position. That said, over the course of 2022, we have been seeking Chinese companies that we believe are going to be the growth leaders in the coming years rather than the tech giants that led the market in the last decade.

Given China’s dependence on imported fossil fuels, we believe the country’s green energy sectors are particularly attractive as we expect prolonged secular growth in this sector. In addition, we are focusing on smaller Chinese companies with disruptive technologies that we believe are less correlated to macroeconomic and policy concerns. These smaller tech companies tend to pursue innovation that is in line with the CCP’s objectives and face less regulatory scrutiny. We are also positive on the longer term outlook for the Indian market, where we expect demographic drivers and digital transformation to be tailwinds over the coming year.

As investors focused on competitive advantages, growth drivers, and addressable markets at the firm-specific level, we are keenly aware of companies’ operating environments. We believe there are few, if any, equity investors who can claim a fundamental competence, let alone an "edge" in divining the intentions of the Chinese leaders. More important to successful longer-term positioning in China, in our view, is to seek out companies with great growth potential, whose products and services are aligned with the government’s strategic priorities, and keep a watchful eye on the policy environment.

Coming out of the recent National Congress, it appears China’s policies will continue to have a dampening effect on the growth prospects for the private sector. We will continue to monitor policy direction and continue to be nimble and decisive in adjusting portfolio exposures in response to any country or regional concerns.

 

¹ All underweight references are in relation to the MSCI Emerging Markets Index.