Regulatory Changes in China and Our Approach to Risk Management
The past nine months have been extremely challenging for Chinese equity markets. The Chinese government has ramped up regulations in multiple sectors (internet, property, education), leading to a significant correction in most of the country’s stocks. At Oakmark, the internet sector is of particular concern given our holdings and the fact that these companies are among the largest and most successful companies in China.
Beginning with the cancellation of Ant’s IPO in November 2020, over the past year the Chinese government has rolled out multiple new regulations targeting the internet sector. These include the new Anti-Monopoly Law, Personal Information Protection Law (PIPL), limits on the time youth can play video games and increased protections for new economy workers. The new regulations have seemingly come without notice, and the scope and speed by which they have been implemented have spooked market participants. This fear has also led many down a slippery slope, speculating that the government is looking to handicap its own internet companies, destroy foreign capital and/or reverse the country’s long-term trend of opening its economy.
While it can be tempting to draw these types of conclusions, we have not seen sufficient evidence to affirm these theories. Instead, we believe that the majority of the new regulations are quite reasonable. One does not need to look far to see that the negative externalities arising from the rapid growth of the internet economy in China are often the very same issues that have raised concerns in the West. Case in point, Western internet companies have been fined billions of dollars for improper use of consumer data, multiple U.S. and European regulatory agencies are investigating several Western internet companies on anti-trust grounds, and certain U.S. states have sought to enhance protection for gig economy workers. A careful review of the various regulations in China indicate to us that the government is looking to prevent abuses of power, protect consumers and, more importantly, create a stronger foundation for long-term sustainable growth. We would also surmise that in the Western world, if governments had the power to unilaterally increase regulations on the internet companies, they would very likely do so.
While we believe the new internet regulations are largely well intended, we would be remiss to not point out that investing in China carries unique risks. It goes without saying that China is not a democracy—it runs a system of government that is fundamentally different from the West. Therefore, it should not be surprising that the way in which the Chinese government manages its country does not resemble the West. In a one-party system, the government has far greater power and control. Companies that operate in China must adhere to the policy direction of the government or risk having their business impaired. Admittedly, for investors, this can be uncomfortable and create uncertainty as new rules often come down swiftly and decisively with less input and consideration from the various constituents.
At Oakmark, we have always been cognizant of the investment risks in China and have spent considerable time thinking about how to incorporate them into our assessment of a company’s intrinsic value. For example, we use a significantly higher discount rate when valuing Chinese companies relative to those domiciled where the rules and regulations are more collectively determined. Additionally, we believe that China is among the most, if not THE most, competitive internet market in the world. The speed at which the competitive landscape changes as well as tremendous innovation that has come out of Chinese internet companies are truly amazing, in our opinion. Yet, this intense competitive environment and constantly changing technological backdrop, all else equal, require a more conservative set of assumptions when valuing these businesses as the range of outcomes is wider. Finally, there are other risks we have been wary of, such as the artificially low tax rate paid by many Chinese internet companies. More recently, the government has tightened qualifications for the Key Software Enterprise tax incentives, which are likely to increase taxes on internet companies going forward. Here again, we have always assumed tax rates would normalize over time.
Many people ask the question, “Has China become un-investable?” While we recognize that the regulatory environment has become more stringent, we have not seen evidence to suggest that China has changed such that businesses cannot operate fairly and shareholder rights are not being respected. Rather, the fundamental question we ask ourselves at Oakmark is, “Are we being compensated for the higher risks in China?” When one adds up the various risks we have explicitly priced into our Chinese holdings, what becomes clear is that the bar for these companies to get into our portfolios is exceedingly high. This is one of the reasons why we have historically had lower exposure to China. Our overall China weight across our international and global portfolios was typically only 4% to 5% before the regulatory announcements.
As the situation evolves, we will continue to do our due diligence and stress test our qualitative and quantitative assumptions. Today, we remain optimistic about our holdings as we believe the market is discounting an overly pessimistic future and the risk reward is quite favorable. Of course, nothing is certain. Given the risks, we will be cognizant of the overall weighting of Chinese companies in our portfolios to serve as an additional layer of risk management.
The Oakmark Global, Oakmark International and Oakmark International Small Cap Funds’ portfolios tend to be invested in a relatively small number of stocks. As a result, the appreciation or depreciation of any one security held by the Fund will have a greater impact on the Funds’ net asset value than it would if the Fund invested in a larger number of securities. Although that strategy has the potential to generate attractive returns over time, it also increases the Funds’ volatility.
Because the Oakmark Global Select Fund is non-diversified, the performance of each holding will have a greater impact on the Fund’s total return, and may make the Fund’s returns more volatile than a more diversified fund.
The stocks of smaller companies often involve more risk than the stocks of larger companies. Stocks of small companies tend to be more volatile and have a smaller public market than stocks of larger companies. Small companies may have a shorter history of operations than larger companies, may not have as great an ability to raise additional capital and may have a less diversified product line, making them more susceptible to market pressure.
Investing in foreign securities presents risks that in some ways may be greater than U.S. investments. Those risks include: currency fluctuation; different regulation, accounting standards, trading practices and levels of available information; generally higher transaction costs; and political risks.
Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods.
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Certain comments herein are based on current expectations and are considered “forward-looking statements”. These forward looking statements reflect assumptions and analyses made by the portfolio managers and Harris Associates L.P. based on their experience and perception of historical trends, current conditions, expected future developments, and other factors they believe are relevant. Actual future results are subject to a number of investment and other risks and may prove to be different from expectations. Readers are cautioned not to place undue reliance on the forward-looking statements.