13 Aug 2021
The Chinese government recently published an extensive regulatory overhaul of the education sector, including a prohibition on accepting overseas investment.
These new measures have a large impact on the After-School Tutoring (AST) space - not only will classes be significantly limited but they will need to be non-profit, cannot be funded by listed entities and foreign ownership will be restricted. It appears the overall aim is to reduce the cost of education on children and families.
The trust has a relatively small exposure to education through China Online Education - a company that provides a platform for foreign teachers to teach students English. We had been wary of potential regulatory changes to the AST segment and exited other holdings earlier this year but didn’t factor in a ban on overseas teachers - clearly a misjudgement.
Although it is tempting to connect these changes to the internet sector, we see them somewhat independently. The thrust of the regulatory changes in the internet space has been around antitrust and data security, policies which have been in the works for some time and in many ways have lagged other countries in terms of basic "infrastructure".
Politically, education is a sensitive area and represents one of the so-called "three mountains" - areas where cost pressures can exacerbate income gaps in society. The other two “mountains” are medical services and housing. We see regulation around these three areas becoming more prominent and are very focused on this as investors.
In terms of valuations, many companies in the tech space are now trading at historical low valuations and at significant discounts to global peers. There is potential for business models to change and we are adjusting down our expectations around monetisation levels in certain companies. Having said this, investment is all about risk-reward and, for many names, this is looking favourable after recent moves.
As these measures are harsher than expected, investor sentiment towards the sector has fallen sharply. Until we see an inflection point ‒ where investors believe the interests of the private sector will be protected - I believe the risk premium to the Chinese equity market will remain elevated. This is particularly the case for exposed sectors and I have been factoring this in across all holdings. I’m also reviewing various stock opportunities, which have been sold off indiscriminately, as the fundamental drivers of the China consumption theme remain intact.
The longer-term aim of these policies, including population growth and promoting a more level playing field with regard to competition, will also have implications through the creation of new businesses, the transition of outbound shopping towards the onshore market and the emergence of local brands. These are long-term sustainable drivers that will support consumption across China.
I do not currently have any positions in Chinese AST /online education stocks, but maintain exposure to Chinese ADRs. Most of these positions are held across the ADRs and Hong Kong dual-listed names, where we have the option of converting the ADR holding into Hong Kong-listed shares due to the fungibility of the ADR and secondary-listings in Hong Kong. Over recent months, I have been leaning towards the Hong Kong/China listed option wherever it is available.
We also observed that after Alibaba’s secondary listing in Hong Kong, several others have followed suit ‒ JD.com being a prominent example. It would not be entirely unexpected to see this approach emulated by companies whose access to capital markets is only through ADRs currently.
The thesis for all positions is consistently evaluated for a variety of risks, including political risks. While ADRs are currently out of favour, the thesis for all holdings is primarily driven by the attractiveness of business fundamentals; as long as these are not disrupted, I see merit in riding out the uncertainty that results in short-term swings in sentiment. This was evidenced by our recent experience with Alibaba, where the regulatory pressures considerably weakened sentiment and yet the importance of the Alibaba ecosystem to the Chinese consumption landscape remained intact.
Meanwhile, China is seeing an emergence of technology-driven businesses models that have a viable runway of growth and can develop into the business models of the future. Looking ahead, it may be likely that Chinese companies aiming to raise capital will prefer the safety of local regional markets such as Hong Kong or China’s onshore markets. In the short-term, we can expect regulatory scrutiny to be the norm across some sectors and this will have an impact on overall market sentiment.
I have always maintained that we need to assess the durability of the individual stock thesis consistently. I used this exact approach during the Covid-19 market movements and I continue to do so now. While education and related expenses weigh on Chinese households - and this announcement intends to bring those pressures in check - the e-commerce ecosystem is a key contributor to the Chinese consumption model. It not only brings goods and services to a wide network of consumers, but it also creates business and employment opportunities for the wider population.
I do not dismiss the ongoing regulatory pressure and it appears likely it will prevail in the near term. Nonetheless, I maintain that the best-in-class companies will have the management capabilities and deeper pockets to be able to respond constructively to these challenges.
This news has spooked the market and also highlighted the need for greater focus on potential regulatory impacts when assessing companies. We did not own any education companies predominantly for valuation reasons, but there is a chance of other parts of the market being impacted as the market extrapolates negative news flow to other stocks. For example, sentiment towards the internet sector will likely remain weak given it is currently being scrutinised by regulators. However, our exposure here is through Alibaba, a company that has been at the forefront of regulation, but whom the antitrust risk is known and less of an overhang.
With regards to the education sector, we saw the initial news of regulation in March as an opportunity to buy Focus Media, China’s largest operator of indoor advertising media. On this news, its shares were down significantly on rumours that all online education platforms would be banned from advertising. Upon our assessment of the numbers, we found that less than 6% of Focus Media’s sales came from the education sector.
Taking the worst-case scenario of a full advertising ban, this created a mispriced opportunity, especially when factoring in very strong advertising demand and that Focus Media’s displays operate close to full utilisation. This high utilisation rate suggested lost business from education could be made up from other sectors such as fast-moving consumer goods and electric vehicles. Valuations looked attractive (and still do), especially based on its strong returns outlook.
We were anticipating some restrictions on the education sector driven by the government’s desire to reduce the cost burden on families and reverse demographic trends. However, the final regulations are shaping up to be much more severe and the government could mandate the whole sector to be not-for-profit. This has led to a significant correction in the valuations of education companies. The portfolio had small exposure to New Oriental Education, but we have now sold as these new guidelines were announced.
As longstanding investors in the region, we are not new to a changing regulatory environment, particularly in China where regulations continually evolve. For example, in the internet sector, previous regulations around search results (Baidu), gaming (Tencent) and e-commerce (Alibaba) have meant that businesses have had to change their business models and move on. These changes haven’t affected the ability of these companies to innovate and continue to grow.
We don’t see the regulations in education and other sectors as linked and this gives us some confidence that once business models have adapted, several of these companies will go on to create value in the future. Rather than take a top-down view, we think it’s important to identify businesses that can successfully adapt, improve the sustainability of their business model and continue to innovate. Such companies will still be able to create long-term value.
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