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.

Quick review of Chinese Tech Stock selloff – what does Mr. Market know that you don’t

Chinese tech names are hit hard in the past few months. As holders of a handful of them, I’m curious to know what Mr. Market knows about them that I don’t.

Starting with Tencent, game monetization approval is indefinitely halted, corporate structure is shaking up. Maybe that’s why it lost 38% of its value in past 180 days. How about JD? Founder CEO Richard Liu got into this sexual assault scandal. That must be why it lost 48%% of its market value. YY? Oh, that must be because the new type of short video, e.g. Douyin/Tik Tok gaining traction leading to it’s 43%% market valuation evaporation. BABA? Jack Ma retiring must lead to 34% market value drop.

Well, if they are plausible, what about BIDU, WB, NTES, MOMO, SINA, CTRP & GDS who all happened to lose 30-50% from their recent high? Are there plausible fundamental reasons to explain each of them incurring so similar negative returns? I’m sure financial journalist could help find them if they want to. However, it looks to me such synchronized movements could hardly be explained well by idiosyncratic risks. I just want to see how much these movements are synchronized (correlated), thus can be attributed to market as a whole, rather than for each specific name.

I’m a R person, and below I try to do some simple statistic summary. I also attached my R scripts in markdown file for whomever is familiar with R and may want to play around with it.

Download R Markdown Notes: Link

  • Here is how daily close price looks in past 180 trading days:20181017_1_StockCharts
  • Here is the performance and max drawdown in same period


  • here is the correlation matrix & its visualization


All these large blue dots indicate highly correlated daily price movement between these names, as well between single names and CQQQ (a Chinese tech ETF).

  • Let’s try to do a linear regression for YY to see how we can use CQQQ’s return to explain YY’s.

First, scatterplot the return of them, the best fit line already looks positive and close to 1.


Based on below linear model, slope of CQQQ is highly statistically significant (p value basically is 0). In other words, CQQQ’s return has high power to explain YY’s return. Note YY is less than 3% of CQQQ’s holdings.




In conclusion, my interpretation is that Mr. Market may not know more about each of these individual company than I do, rather it may be more driven by overall fear to macro events.

Investor Letter – 2017 4Q

Below is general commentary section excerpt from my investor letter for 17Q4

Download pdf: TaoValue_2017_Q4_final

General and Market Commentary

If anything is to be remembered for the financial markets in 2017, the lack of volatility will be on the list. S&P 500 index, for an example, finished positive for all 12 months, unseen for majority of the investors living today. The unprecedented financial market quietness was also accompanied by the mania in cryptocurrency as all major cryptocoins pocketed astronomical returns for 2017. It is not hard to identify bubbles everywhere under traditional definition, but I find it is meaningful to think through a level deeper. Below is my attempt to find some common lessons by doing quick studies of “bubbles” in three distinct markets. As always, I like to think about the most controversial ones, as they are the most “information-rich”. I hope they are interesting read for you as well.

Tesla (Public Market)

2017 is not Tesla’s best year, as it underdelivered the dream they sold before about Model 3 by large margin. However, Tesla bears are bewildered by the lack of reaction of Mr. Market to negative developments. One possible reason to this phenomenon is the bulls’ almost religious belief in Tesla. That means the time for Tesla short to work out is not the “change of the fact”, but rather “change of collective perception towards the changed fact”.

To see whether this positive collective perception is justified, I think of the Tao (i.e. the societal value it creates and the corresponding return it takes) of Tesla. An alternative way to see it is that Tesla may be Elon Musk’s clean energy social campaign disguised as a corporation. If you in 2003 were given a mission to push the global auto industry to a more innovative and socially responsible (e.g. cleaner energy) direction, what would be your estimate of the time line and budget? Tesla single-handedly took about a decade and 0.08% of the societal value created in 2017 (Tesla EV/Projected 2017 Gross World Production). Not a bad score for a social campaign.

However, whether the incremental societal value would be entirely accrued to Tesla in forms of shareholder value is uncertain. This is why I wish Tesla could have remained private, thus funded by more loss-tolerant classes’ wealth. I also wouldn’t short it, because there is still possibility some incremental value could accrue to Tesla through M&A.

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A Valuation Framework for Bitcoin

There is no new thing under the sun.

– The Bible

Disclosure first: This piece might be sacrilegious to many value investors. In Nov 2013 (yes, the last Bitcoin “bubble”), I put a small percent of my net worth then into Bitcoin. I have been holding and plan to hold them until it reaches my estimated value (showed below). Please do NOT see this piece as a defense to Bitcoin critics or as investment advices (In fact, I am always ready to change my view, however I just didn’t come across convincing counter-arguments. Or put it differently, I’ve been most of the critics’ place and held similar suspicion before but changed later). I see this piece as an alternative thinking framework to a potential significant invention in human history, and I welcome any sort of comments/feedbacks/critiques.

A few lemmas I want to establish before going further:

  1. The universe we live in consists of two and only two elements: energy and information. (mass, or material, could be unified to energy by Einstein’s famous equation: E = MC^2)
  2. Bitcoin’s value is binary (i.e. it should either 0 or something very large, there is no middle ground)
  3. If “intrinsic value” is defined as “present value of expected cash flow from a value producing asset”, Bitcoin (as well as all kinds of money) has NO intrinsic value.
  4. Global governments as a whole, is not as prudent and resposible as developed counties’.
  5. I have been wrong and could be wrong on Bitcoin

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Chinese ADR “Go-Private” Deals Overview-  A Changyou Buyout Inspired Study

On 5/22/2017, Changyou [CYOU] received a preliminary non-binding offer from its chairman Dr. Charles Zhang, who is also the CEO and Chairman of Changyou’s parent company Sohu, to take the company private with and offer of $42.10 per ADS. The offer letter can be seen here: It is interesting that it is Charles Zhang, the person, not the parent company Sohu, to make the acquisition.

As a current CYOU shareholder, I think it’s a OK deal despite I had higher expectation of the turnaround execution which just started to show some positive signs. As of 5/31/2017, there is still about 8% spread between the close price of $38.9 and offer price $42.1. If the deal could be closed timely, it would be a good risk arbitrage opportunity.

Inspired by this event, below I did a general study of all the Chinese ADR “go-private” deals in past few years. I’m keen to get answers to these 3 questions (which could help me evaluate upcoming similar deals’ risk/reward):

  1. How much percent of these deals fell through?
  2. What are the characteristics of the failed deals? (does CYOU have any of these traits?)
  3. How long do they usually take to close?


History of Chinese ADR Privatization Deals

Let’s begin with a rough understanding of a typical ADR privatization process. Credit to a Credit Suisse’s study [link here], here is a great chart showing the 6 milestones of such a process.


It is also important to understand the main incentive of such privatization deals, specifically for these US listed Chinese companies. Like most of the PE backed LBO deals, Chinese ADR privatization deals also target for a relist for higher valuation. However the difference is that, rather than streamlining and growing the businesses for a few year in private arms (in LBO cases), the Chinese ADR companies could seek a faster re-valuation by relisting the firm to its home market (which offered richer valuation, especially back in 2015 before the crash). This also explained why there were so many proposed deals announced in 2015.

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How much do finance people make in Chicago? – 2016 CFA Compensation Survey

Following the 2015 comp survey (find 2015’s number in this old post), CFA Chicago Society recently published 2016 version. This is the second year of this informative survey. PDF report can be downloaded from the link at the bottom.


Download link: compensation_survey_2016



Indirect Hard Lessons – Gurus’ Recent Mistakes

As an old saying says, “you best teacher is your last mistake.” However what’s challenging for value investors is that it’s very difficult to realize you’ve made a mistake to start with. As you are always going against herds, you’ve already made “mistakes” in others’ eyes, meaning you are left alone to make the judgement. Plus, you have to re-convince yourself about your verdicts when the name keeps going down after your purchases, or if the names move higher you just cannot stop feeling good about yourself, either way it’s really hard to maintain an objective view on your own past decisions.

Market recently has seen some big failures on names backed by some legendary value investors. Although may not be able to learn the lesson as deeply as the investor themselves do, I found these are great case studies nonetheless.

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