Offshore investing

Orbis: Unpacking the risks from regulatory change

For Chinese companies, regulatory change is a perennial risk. In July, the government gave investors a stark reminder of that risk when it announced sweeping changes to China’s online tutoring industry. Amid other headlines, this led to a broad sell-off of Chinese technology stocks. We think the panic was excessive. But regulatory risk has increased, so while our offshore partner Orbis continues to find their Chinese holdings very attractive, they have resisted the urge to add materially to the Orbis Global Equity Fund’s already-large overall exposure. Rob Perrone from Orbis discusses.

China’s top government bodies recently issued new guidance overhauling the tutoring industry. The changes focus on services that supplement the core kindergarten to 9th grade (K-9) curriculum, where the government is concerned about high burdens on students and high costs for parents. Among other changes, the guidance says that K-9 tutoring companies must restructure as non-profits and cannot list or raise capital abroad – including through the so-called variable interest entities (VIEs) used by China’s tech firms to provide economic exposure to foreigners. When the news leaked, online tutoring stocks crashed so violently that market leader TAL Education now trades for less than the value of the cash on its books.

Its peer Youdao, a sizeable position in the Orbis SICAV Emerging Markets Equity Fund (EM Fund), has not been immune to the industry’s share price or fundamental pain. Its shares sold off as much as 67%, though we believe the impairment to intrinsic value should be smaller. K-9 tutoring represents only about 30% of Youdao’s revenues, with the rest coming from services such as high school tutoring, college English training, advertising, and hardware. And we believe the guidance on foreign listings will not impact companies like Youdao that are already listed. In that context, the price decline looks severe, but the changes were announced in an unusually abrupt way, so uncertainty is unusually high.

Outside of the EM Fund, Youdao is a small position for the funds that hold it. But Youdao’s majority owner, NetEase, is a much larger holding across the funds. The direct impact of the tutoring overhaul should be minimal for NetEase, however, as Youdao is less than 2% of its size by market value.

Indirect impacts are a greater concern

For NetEase, along with larger peers like Tencent and Alibaba, the regulatory fear is not about what has happened, but what could happen next. (Tencent is the key underlying holding of Naspers, a large position in several Orbis and Allan Gray funds, and Alibaba is a significant holding in some funds.)

Plenty has happened already. In the past month alone, Tencent temporarily suspended user signups for WeChat, tech regulators announced a six-month campaign to tighten oversight of internet platforms, Tencent Music was ordered to dissolve exclusive licencing deals, delivery services were told to boost driver pay, Alibaba and Tencent were forced to further open their ecosystems to each other, firms planning initial public offerings (IPOs) learned of new data security reviews, anti-trust regulators rejected a merger of two Tencent-backed companies, twenty-odd businesses were fined for anticompetitive acquisitions, and, just days after its New York IPO, ride-hailing firm Didi was removed from Chinese app stores for data security violations.

For NetEase, along with larger peers like Tencent and Alibaba, the regulatory fear is not about what has happened, but what could happen next

This rapid pace of headlines is unusual, but the broader regulatory push is not new. Alibaba has been under intense scrutiny since last November, when the government abruptly scrapped the IPO of its affiliate Ant Financial. Alibaba has met with regulators, paid fines, and ceased practices like forcing merchants to “choose one of two” e-commerce platforms. E-commerce remains a great business for Alibaba. Tencent has also weathered scrutiny, and has likewise met with regulators, paid fines, and changed some of its advertising practices. Advertising remains a great business for Tencent. And a few years back, both NetEase and Tencent faced a suspension in video game approvals. They worked through it, adding new player verification and child protection measures to address government concerns. Gaming remains a great business for NetEase and Tencent.

Looking across recent Chinese regulatory headlines, some common threads emerge: Don’t squeeze families, customers, employees, or small businesses. Don’t abuse a monopoly position to hurt competition. Don’t raise capital without the local regulator’s blessing. Don’t be greedy or sloppy when collecting personal data. Be responsible corporate citizens.

Many of these actions mirror rules already in place in the US and Europe. Of course, the rule-making process in China is less transparent, less predictable, and often more sudden. That increases risk, which we manage with one eye on valuation and the other on portfolio-level exposures. If we could buy these businesses in the US, we would be willing to pay more for them and hold more in them.

China’s technology leaders have proven themselves to be highly adaptable

But they are in China, and the good news is that we do not believe the Chinese government is out to destroy the tech sector. Here, we have been encouraged by the efforts of China’s state media to calm local investors, and by the securities regulator telling international banks that the country wants to regulate – not ban – foreign listings and VIEs.

If anything, the experience of NetEase, Tencent, and Alibaba over the years suggests that innovative companies can do well even under tighter rules. China’s technology leaders have proven themselves to be highly adaptable, and those that continue to adapt should continue to thrive.

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