Is China Uninvestable?

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There's too pessimistic of an assumption as to the Chinese authorities' interest essentially blowing that up and wiping out global investors.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Jason Su. He's a renowned market researcher turned asset manager, most recently in China. U.S. shares of Chinese companies were routed this past week. I laid out some bearish concerns for Barron's readers. Jason has the bull case. We'll hear both in a moment. Listening in is our audio producer, Jackson. Welcome back, Jackson. How was the wedding? And if she left you at the altar, you do not have to say anything here. I hope it wasn't for another podcast producer. Look, was it one of those audio big shots from the Wall Street Journal? Because I will let them have it, and my tone will not be public radio soothing. It'll be sports call-in show argument.

She stayed at the altar the whole time. It was all okay. We had our families dance. We had a lovely wedding, and then afterwards we went backpacking on the Olympic Peninsula. So It all worked out.

Well, it's, it's wonderful news. And congratulations again. I never doubted the two of you for a moment. Now then, China started this past week with deep stock declines, especially for companies that trade in the U.S.

The Chinese stocks falling the most since 2008.

This is the Nasdaq Golden Dragon China Index. This was the worst day it has ever had.

Given all of the turbulence we've seen, are Chinese stocks investable?

Alibaba lost 12% on Monday. A video gaming company called NetEase fell 10%. Baidu, the Chinese search giant, dropped 13%. All of these companies are listed in the U.S. through what are called American Depository Receipts, or ADRs, which means U.S. investors can buy and sell them as easily as shares of Amazon or Alphabet. The declines were driven by politics. Xi Jinping, who many are calling the most powerful Chinese leader since Mao, secured a third 5-year term as head of the country's ruling Communist Party. That broke with precedent, but it was signaled well in advance. What might have unnerved investors more was Xi replacing market-friendly technical experts in his leadership group with yes-men. Consider the backdrop for U.S. investors. Years of tariff spats between the U.S. and China have given way to open battle for access to high-end computer chips, with Taiwan at the center. We talked about that last week. Early last year, we also talked about the brief disappearance from public life of Alibaba founder Jack Ma after he criticized Chinese officials over the regulatory treatment of the company's Alipay fintech business. A planned Alipay IPO was scrapped. Ma has resurfaced, but he now keeps a low profile. Alibaba shares were recently down 78% over 2 years. There have been other crackdowns against Chinese tutoring companies that trade in the U.S. and a ride-hailing company called Didi, which had a U.S. IPO last year. And a delisting this year. Put it all together and investors are left wondering whether Xi might take some broader action that hurts U.S. investors or reins in China's tech companies or both. The flip side of that is, as always, valuation. Even deeply troubled companies can sell at prices that make the risk worthwhile for investors. And China's top companies are innovative and prosperous. Alibaba is an artificial intelligence leader that makes money from retail, logistics, lending, and more. It has generated $89 billion in free cash over the past 5 years, more than Amazon's $75 billion. But its shares recently traded lower than at the time of their U.S. debut in 2014. The company's market value is down to just a small sliver of that of Amazon. Baidu goes for only 12x earnings. NetEase is 13x. JP Morgan wrote this past week that the sell-off was, quote, disconnected from fundamentals, end quote, presents an opportunity. Maybe it does, but I have concerns that go beyond valuation math and near-term rebound potential. There's an awkward but tolerated hypocrisy underlying U.S. shares of Chinese companies. Companies raise money from investors in two main ways. They borrow, which creates bonds, or they sell ownership stakes, which creates shares. But China bans foreign ownership across broad swaths of its economy, so its companies have used a workaround to tap U.S. cash and trading liquidity. They've set up offshore shell companies called variable interest entities, and they've given these shell companies contractual rights to a cut of their income, but not ownership. They've sold shares of these shell companies to U.S. investors. That means if you own U.S. shares trading under the ticker BABA, B-A-B-A, you don't actually own part of Alibaba. You own part of something that has a contract with Alibaba. When U.S. interest rates were near zero for the better part of a decade, investors were up for just about anything— crypto, non-fungible tokens, meme stocks, blank check companies, and so on. Shares of foreign companies that don't really come with ownership aren't nearly the strangest things investors bought. But we're at a moment of market reckoning where investors are questioning some past assumptions. And the risk to China ADRs doesn't just come from China. U.S. lawmakers are cracking down too. These companies have a record of spotty financial reporting, which isn't an accident. China considers some accounting details to be state secrets. So lawmakers have told hundreds of U.S.-listed Chinese companies to comply or delist. China has said it will allow for more financial reporting. The two sides have created a 3-year countdown. Many Chinese ADR issuers have launched secondary stock listings in Hong Kong. A few, including Alibaba, have applied to convert these Hong Kong, or H-shares, to their primary shares. That would make these companies eligible for something called China Connect, which links trading between Hong Kong and mainland China. Now, there's one more piece to my skepticism on Chinese stocks for U.S. investors, I'm just not sure the returns are worth the hassle. 30 years ago this past week, a company called Eaton Vance launched its Greater China Growth Fund, which gave ordinary U.S. investors a way to buy Chinese shares. That was a relatively new idea at the time. I can still remember the wholesaler sandwiches. A mutual fund wholesaler is someone whose job it is to talk people into talking other people into buying their funds. And I was one of those middle people back then, a stockbroker at a big firm. I did a lot of cold calling. I had very few clients, but the wholesalers didn't know how little I had to offer them. And I always showed up for their pitches because they usually brought sandwiches.

Is it safe to say you put the eaten in Eaton Vance?

I'm going to pretend I didn't hear that. Now, the Eaton Vance wholesaler said, China has a billion people. Its economy is small today, but it's embracing capitalism and freedom, so its economy will soar. And if you get in today, it'll be like getting in early in U.S. shares. And that made sense to me because only a year or so before, I had watched a man on TV named Boris Yeltsin climb on top of a tank in Moscow to defy a communist hardliner coup. And just like that, the Soviet Union was gone. And barely a decade before that, I had done drills in school to prepare for the possibility of a Soviet nuclear strike. So the world was changing quickly. The good news for Eaton Vance is that its fund has beaten its benchmark these past 3 decades. It's returned an average of about 5% a year. Versus next to nothing for the broad Chinese market. A cheap index fund invested in the U.S. stock market returned 10% a year over that time. So what went wrong for China? Not growth. Its economy soared just like the wholesaler said it would, even without an abundance of free market capitalism. But studies over the years have blown holes in the assumption that economic growth and stock returns are closely linked. Economic gains are often driven in part by new firms that haven't yet sold shares to the public, not just the old ones that shareholders tend to own. Also, high-growth economies sometimes have pricey shares, which limits future returns. Today, China's best companies are both tradable and cheap, but they're not immune to the economic slump hitting big tech. Alibaba has slipping revenues and profits and has announced layoffs. Amazon stock took a beating this past week. And did everyone see Facebook, now called Meta Platforms, plunge 24% in a day? That's more than a slow patch for advertising demand going on there. Founder Mark Zuckerberg is spending more than $10 billion a year on a metaverse project that sounds a lot like a big video game, only without fun stuff like shooting robot dinosaurs and with not fun stuff like meetings with the avatars of coworkers. And I say, sign me up, never. And I think other investors are coming around to that view, or at least they're wondering where all that money is going. But this is probably a weird moment for this little departure now that I think of it, so let's power down my Johnny Sidetrack avatar and make our way back to the topic at hand.

I love the idea of you going on the metaverse as Johnny Sidetrack.

What would my avatar look like?

I'm thinking Old West, like, uh, but not cool, not like the cowboy. Maybe like in the very opening scene, like the first person who gets shot by the bad guy.

The first person to get shot by the bad guy?

Yeah.

Thank you for specifying not cool. Okay, China. Its growth and development have been wow, but its stock returns have been meh, and its commitment to investor rights is, uh, which leaves me in the uh-uh camp for now. But I want to give the bull case its due, and I know just the person for that. That's next after this quick break.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, We analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.

Welcome back, partners. Old uncool Johnny Sidetrack here. Jackson, you can turn off my theme music because it's time to get back to China. Not all investors share my concerns about the political exposure that U.S. investors face in China.

So I would say, you know, the pendulum always swings to the extreme.

That's Jason Hsu, founder of Rayliant Global Advisors.

Right. I think, uh, say a year and a half ago, no one thought about it as an issue, right? No one thought about this variable interest annuity, which is just a way to circumvent regulations and highly suspect. And then I think now that people are aware of it, they're aware of that issue and other regulatory issues. And I think there's too pessimistic of an assumption as to the Chinese authorities' interest in essentially blowing that up and wiping out global investors.

Jason is an accomplished market researcher who co-founded Research Affiliates in California, which is best known for its indexes that weight stocks by fundamental measures of value like sales and cash flows rather than by stock market value. More recently, Jason took his findings on behavioral finance and data-driven investing to China, launching the Rayant Quantamental China Equity ETF, ticker RAYC, at the end of 2020. I guess you could call that an unlucky time to launch. The fund is down 35%, but a popular traditional index fund called SPDR S&P China is down 52% over that time period, so Jason is actually outperforming by quite a bit. Glancing at his holdings, the fund emphasizes mainland companies in diverse sectors that don't have much U.S. name recognition, not the big tech firms that trade overseas. But I wanted to know about what to expect for those U.S.-listed companies. Jason expects more of them to repatriate to China, including for their primary listings.

So really completely repatriating the structure into something that actually is direct ownership in the underlying business. And of course, that allows the Chinese government to impose with great transparency the actual foreign ownership restrictions. So it'll be staged out, but that problem will be solved. It will not be solved in a way that is just outright robbing existing shareholders, but I think That's just— there's so much lack of understanding. People bought into that with no understanding what they're buying. And those people, I think, are selling in panic again because they have no understanding of what that transition period and plan looks like.

This gets a little complicated. When Chinese companies with ADRs launch secondary listings in Hong Kong, the Hong Kong shares typically represent ownership in the same shell companies. Not the operating companies in China. Many ADRs are fungible with the Hong Kong shares, meaning investors can technically swap one for the other. But this can be difficult for U.S. investors in practice, and Jason says those with ADRs should sell them and buy Hong Kong equivalents where possible, which would also serve to lock in any tax losses to use for write-offs. But what about ownership rights? And if companies convert to primary Hong Kong listings with China Connect access to mainland trading, what about the ban on foreign ownership? I asked Jason how this repatriation might look over time.

I think what will happen is if Beijing gets concerned with, you know, a company of strategic importance and wants to limit foreign ownership, what they will happen is they'll say, first, we are going to make available for you to relist your shares back in China. And in that relisting process, your job is to go out and make a tender offer and buy back shares so those shares could then be relisted in China. Because obviously they could say you could issue more shares and dilute your Hong Kong shares, but for a big company, that's a lot harder. So they make a tender offer outstanding to all existing shareholders who who held the shares in Hong Kong and say, "Look, everyone gets to buy." And then the company retires those shares and simultaneously issues new shares domestically for only domestic shareholders. In that way, they will increase massively domestic ownership while retiring Hong Kong ownership, some of which will be foreign, some of which would be Chinese companies with a Hong Kong treasury. So that's probably the cleanest mechanism And we're already seeing that happening for Alibaba.

Jason says that Hong Kong listings make companies safer investments because they imply a level of approval from Chinese regulators that U.S. ADRs don't come with. Ownership issues will be fixed, he says, and not, as he puts it, by just outright robbing existing shareholders. Okay, but what makes him so confident? He says it's in China's interest and Xi's interest to promote China's renminbi as a trusted global currency. And not to weaponize renminbi-denominated assets.

The biggest prize for President Xi Jinping is to be a global power, is for renminbi to be trusted as a currency, and is to, in a way, say, "And we will not weaponize our currency, our assets against you," because this is their take on the dollar. It's like, "Ah, you own US assets. If you own US dollar, that can be weaponized against you." He sees an opportunity right now to use that counter-message and say, "This is why you want to clear through renminbi." Now, if he weaponizes and says, "Ah, actually, if you own Chinese assets, we could all of a sudden challenge and take it away from you," then his whole plan, his whole argument of why renminbi should be a global currency goes away. He's instantly weaponizing renminbi-based assets. This is one of his biggest stated agenda. So this, you know, he would not do that.

That's one leg of Jason's bull case for China. The other, as I touched on earlier, is that prices look attractive. Jason says the time to buy is already here.

I would say we're probably very near the bottom in terms of the China shares listed in Hong Kong. It's going to be obviously fear, but there's the fear, then the sentiment could be negative for a while, but I don't think it's going to be much worse than what we're seeing in the market already.

Thank you, Jason, and thank all of you for listening. Jackson Cantrell is our producer. Jackson, you know the secret of a happy marriage?

I'm not familiar.

I mean, you probably should have thought about that before, right? I can use some tips myself. I mean, things are good, but you know, you can't be too prepared. Why don't you read up on it and give me some pointers? Subscribe to the podcast, rate it, review it, tell your friends, tell your enemies. Tweet me at @JackHough, that's H-O-U-G-H. See you next week.

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