Thoughts on China’s Regulatory Landscape

Below is the market commentary excerpt from our recent 2021 Q2 letter.

The Rise of Mr. Government

Modern finance, as a school, was developed by western civilization. Investing, as a derivative of finance, can be said the same. Among all the value investing books published, there are very few mentions of evaluating government as a stakeholder or risk associated. This is unsurprising because the whole western economy system is built upon free market economy theory which believes government should intervene as little as possible. When capitalism grows more mature, we started to see a reversal shift from such premise, most recently in Big Tech regulation, but that is nowhere close to the role Chinese government plays in its economy. This is why I stressed heavily on value creation for all stakeholders, including the government, in my framework.

In the past quarter, we have seen humbling evidence of how important Mr. Government is to Chinese businesses, as waves of looming regulations on Chinese businesses materialized. E.g. the new law curbing private education was released in May. It explicitly stresses the non-for-profit nature of K9 schools and strictly prohibits related party transaction to move the profits out and M&A of schools. In July, the Cyberspace Administration of China launched data-security investigation on a few newly IPO’d Chinese tech firms, most prominently Didi, the ride hailing dominator in China. As I’m writing this letter, government delivered another heavy blow to after-school tutoring industry by releasing the Opinions on “Double Reduction” for Students in the Compulsory Education Stage, which essentially ruled all subject-related tutoring should be non-profit. Against such backdrop, some Chinese stocks suffered panic selling in similar scale only seen in 2008 financial crisis.

Implications on Investors’ Trust

Many called such interventions “unconstitutional”, “confiscation” or “authoritarian”, and starts to claim that Chinese stocks are not investable at all. I don’t fully agree with such view. For private education, I was supportive for certain tighten-up by stating “Without a sound regulatory framework, such a market is destined to be flooded by greedy and predatory players” in my last letter. Chinese government & economy, in my opinion, is a very complex hybrid system with its own merits. It seems to me that most western observers do not understand it and tend to use century-old ideology to over-simplify it. Taking one recent example, Charlie Munger in his interview with CNBC on June 29th, 2021, touched on Chinese regulation, crediting China by saying “…a wise regulator stops this stuff [Archegos’ meltdown] before it starts…what interests me in this is that the communist Chinese behave the way I am talking in favor of”. Such response disturbed even many value investors who are known for following Buffett & Munger as a cult. It seems to me that such misunderstanding is widespread and now exacerbated by the political tension between US & China. Without a deep understanding of how China works, foreign shareholders won’t be able to hold through turmoil like this one.

Widely in western investing frameworks, there are generally two pillars: fundamentals (related to the company) & valuation (related to Mr. Market). For a sound framework for future investing, I believe a third pillar of same significance on regulation (related to Mr. Government) should be added. Before this point is fully ingested by global investors, Chinese companies listed overseas may lose confidence in general and may carry lower valuation than global peers.

Our Understanding of the China Model

Helped by a hybrid model of socialism & capitalism, China, with over 1 billion population, grew its GPD per capita from $195 in 1980 to $10,262 in 2019. (i.e., a 52 folds jump or 11% annualized growth over a 39 years period!) Yet, critiques claim that this model is not based on a plural political system and that it is authoritarian. It is fair to say that the top priority of Chinese Communist Party (CCP) has always been maintain its power, which is true for any political party. What’s unique about the China model, however, is that CCP desperately tries to justify the legality of its power in a practical way – that it must be earned by improved welfare of the whole society.

Without the Separation of Powers, Chinese public administrative system serves legislative & executive roles at the same time. A typical process runs like this: 1) Central government drafts, solicits feedbacks & finalizes guidance documents. Such documents are conceptual and brief in nature; then 2) Individual agencies or Local governments use discretion to interpret the guidance, to design detailed policies & to enforce the implementation.

Such unified power, while with good intention, can utilize the best parts from socialism & capitalism and can be very effective and flexible. Take one example from not far ago, China started promoting Electric Vehicle (EV) around 2010. The market was initially swamped by players who built “cars” that better to be described as toys, only to cheat for subsidies. Over time, the government iterate through few versions of regulation, e.g. using technical specs like range to scale subsidy. Nowadays, China has multiple EV brands that can compete locally at the same level with market leading Tesla. Some of the EV technology developed by local EV companies like BYD are also recognized by global auto manufactures like Toyota in form of partnership.

After observing generations of such policies, I think the China model typically overshoots at the initial stage with little fear of making mistake (e.g. over-promoting if it intends to promote; & over-curbing if it intends to curb), but is generally fast in iterating and finetuning towards the conceptual goal identified by the central government.

The Great “Retailization” of US Market

It is an short excerpt from my 2020 Q4 letter [Link], but it felt like long time a ago since the GameStop story folds out. I think this new phenomenon may have profound impact to the market structure. For example, how do we define a “right” price, and what is “market manipulation” exactly? Historically, price manipulation happened when few entities comer the market and set price by transacting between colluded parties. In that way, such price is not “right” because it’s not agreed by a widely participated market (i.e. an authoritarian price). If the “right” price is defined as the price agreed by majority in a widely participated market (i.e. a democratic price), isn’t the currently price of GameStop (closed at $347.51 on 1/27/2021) a “right” price? and if it’s a “right” price, where is the “manipulation”?

One hallmark of US equity market in 2020 is what I called the great “Retailization”, where the asset pricing function seemed to heavily shift to the hands of retail investors. Lately, I was able to get hands on a proprietary dataset which confirmed this phenomenon. On left chart below, you can see the retail trades in % of total equity market trades held at a level of 12% from 2017 to early 2020, then jumped up to a level of 25% in late 2020.

Additionally, retail is not “dumb” money anymore! At least judging from short term return perspective. On the right-hand side chart below, you can see a hypothetical one day holding period L/S strategy to buy the 10% most bought stocks by retail investors on that day and short the 10% most sold stocks at the close and exit positions at the next close. The most obvious thing you would notice is the clear infection point in March 2020 when US shut down for the pandemic. Even before that, this signal still predicts positive one day forward return (i.e., the prices follow what retail investors flow), yet in a milder form (13~% annualized return). Since March 2020, such signal started to show stellar predictive power, leading to a 97% annualized return! This is a solid confirmation, using data, that Mr. Market now is basically a retail trader.

Now that we see the “what”, it is important to think about the “why” (it happened), and the “how” (to prepare for it). There is more retail participation as the market share analysis shows, but there is still 75~% of institutional flow. However, if we try to break it further down by active & passive flow, and assuming passive institutional flow are not pricing assets, we can argue retail now has a much stronger hand against active institutional flow, especially in certain sector (e.g. tech), or certain stocks (e.g. Tesla).

Looking forward, I start to think about the implication, here are what could happen (or may already be happening):

  • The rise of a new breed of investor, who make “profiting in stock market” seemingly easy.
  • The rise of star fund managers using new paradigms.
  • Capital Market are transformed by an influx of new personnel who only had experience of a prolonged bull market.

In case you have not noticed, I just copied some description for the Nifty Fifty bubble in 60s to 70s. The parallel between now and then seems obvious, yet I think there are a few nuances in today’s market: 1) I believe businesses today have a sounder fundamental, which probably only seen in the last Industry Revolution; & 2) The speed of information is exponentially faster than in the 70s. This leads to me to think that we may be at the beginning of a larger “bubble” than Nifty Fifty, yet in a faster pace. I think that new paradigms today have their merits but will very possibly be pushed to extreme by elevated retail participation. One key lesson from Nifty Fifty era is that valuation still matters even though one can do fine in long term if holding great businesses through a huge bubble.