Monthly Market Commentary - July 2021



In a world characterized by a benign attitude towards risk at hefty valuations, it is a shock to many to see Chinese Big Tech stocks fall at such rapid pace. I am not talking underperformance here; I am talking about blue chip stocks down 40-50% from their highs in a matter of 3-4 months. It is a nasty move that hurts portfolios. Being a contrarian by nature, this negative move got my attention and I started doing some research on these names and attend online events organized both from the sell and the buy side. In one of these events, a fellow fund manager indulged quite a lot of time on the "existential" risk of owning Chinese stocks. Soon my memories went back recollecting my (failed) attempt of understanding Existentialism. Trying not to be too harsh with myself I must admit that existential philosophy is a very complex field and I read on the topic in my 20s. Probably, I was not old enough to get, at least, the big picture. In a nutshell, Existentialism is a philosophical movement that started in the mid-40s in France. Jean Paul Sartre it is widely known as the father of Existentialism, but writer Albert Camus was also a great contributor. Several commentators trace its origins back to the works of Kierkegaard and the nihilism of Nietzsche. These thinkers explored issues related to the meaning and purpose of human existence. The archetypical attitude of the individual can be found in the book "Nausea" by Sartre. The common trait of all humans is a sense of "angst", confusion or anxiety when confronted with an apparently meaningless or "absurd" world. To these philosophers, "existence precedes essence". Individuals shape themselves by "existing". The actual life of the individuals is what constitutes and could be called their "true essence". This contrasts with the point of view of almost all religions. It also contradicts positivism and rationalism. Left alone in the world, the existentialist must find his "authenticity"; not an easy task, often a cause of despair. His freedom is limited by a condition known as "facticity": a limitation dependent on things one did not choose (such as the birthplace, the family) or cannot change (like the past). Anxiety, confusion, and despair is what investors in Chinese stocks have felt lately. In a long series of events, the Chinese government tried to put limitations on the rise of private enterprise. First, we had a stop on new games that affected Tencent and Netease in 2018. Then, the government started a campaign against Jack Ma and Alibaba that culminated with the canceled IPO of Ant Financials last year. Recently, in a rapid series of interventions, the Chinese government ruled against Didi and its IPO in the US and the tutoring/online education businesses transforming them into no-profit organization overnight. Certainly not a constructive environment for shareholders. Despite clear lack of communication skills, all the government moves can be easily understood as a paternalistic approach to do the "social good" while retaining all the levers of control. However, when we were touching on the existential risk of owning Chinese equities, we were referring to a peculiar structure related to Chinese stocks known as VIE, variable interest entities. It should not be a surprise to you that every time you buy an ADR of a Chinese company in the US or even in Hong Kong you are not owning a piece of the business. You own a certificate that gives you the right to benefit from the economic results of such business. The two are quite different things. Under this set up, it is conceivable that one day the Chinese government will simply declare unilaterally that such contracts are not valid anymore and you will end up owning nothing. The VIE structures go back over 20 years. They allowed Chinese companies to raise substantial amounts of capital in developed markets. I first encountered this arrangement when reading the Alibaba prospectus at the time of IPO. I was surprised that nobody complained about this very weak corporate governance. Many years have passed since, and I am surprised that investors bring it up only today. To me, this is a sign that the sentiment towards this area is extremely negative. I will try to explain why. It is true that the VIE structure is not ideal. However, as an existentialist would say, this is "fasticity". Its own existence determines its essence. This is the Chinese stock market, take it or leave it. The real question is "will the Chinese government wipe out investors?" We cannot be 100% sure of anything but we must get the probabilities right. To me the likelihood of such an extreme "black swan" event is very remote that we can live with it. Ten years ago I was not so sure. Most of the investors in the VIEs were westerners trying to get some exposure to the rapid growth of the country. Today, VIEs represent over 2 trn USD in assets. Since the establishment of the "stock connect" a meaningful number of locals, both individuals and professional investors, invested in these stocks in Hong Kong though the VIE structure. So, the government has no incentive to cause such a disastrous destruction of capital for both domestic and international investors. My expectation is that, over time, they will facilitate fungibility between Mainland and Hong Kong even more. Therefore, my recommendation is to invest through Hong Kong already. Additionally, China needs financial markets. If you get the statistics right, in the last 10 years the number of IPOs in China outnumbered all other countries, even US. This is not going to change in the foreseeable future. At the same time, it is very likely that, in a matter of 20 years, the Chinese bond market will get as big as the US or the Japanese one. It is going to be a bumpy road, but it seems an inevitable path. Having said that, putting the existential risk aside, the 2 trillion dollars question now is "what to do with Chinese tech?". I believe that we are already at interesting valuations compared to history and to international peers. This is already a good entry point at the margin for the long-term investor, even if do not factor any potential future rerating. Do not take me wrong, this does not mean we do not face uncertainties. In the short term, the newsflow can deteriorate further and investors might capitulate. Should this happen, it would represent an opportunity to invest aggressively at attractive prices in a world where we continue experiencing "existential despair" in a desert of value.

Peppe Ganci, CFA

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