Record breaking crash in Hang Seng history

 

Record breaking crash in Hang Seng history
As the mainstream news are focused on the groundbreaking Tokyo Olympics records set by the best athletes in the world, the financial news are focused on the fastest crash in Hang Seng history, which exceeded the records set by the S&P 500 crash last year. As financial markets are increasingly driven by algorithmic trading by institutional investors, I think the trend of rapid and harrowing losses is starting to be an expected trend and not a <6 sigma event> popularized by conventional quant finance. A lot of the narrative in social media / forums seems to be to avoid the Chinese market at all costs and there is lot of retail selling among the paper hands, which prompted me to deep dive throughout the weekend to discern the noise from the facts. Between the choice of averaging up on the most expensive market reaching its All time High in US history VS buying into the crash in the All time Low in HK history, the choice is apparent to me.

Nonetheless, cheaper valuations are not a substitute for proper risk assessment. If I want to invest in HK / China, I need to understand the government’s motivation to their direct intervention into the sector. To my understanding, the government has zero incentive to decimate its tech sector if the Chinese tech companies can create value for society and shareholders according to the social norms encouraged by the government.

Cultural Differences between China and Rest of Western World
1) Rules are Negotiable VS Rules are inviolable
To use the analogy of disciplining the kid/ tech companies,

For the US economy, the culture among silicon valley is that the rules are meant to be challenged and broken. The child has proper human rights and is free to negotiate terms and conditions with the parent. Elon Musk is free to violate SEC warnings for manipulating Tesla Stock price on twitter precovid or breach quarantine regulations set by the government, and the punishment is simply a slap on the wrist. Outright manipulation of Crypto prices by social influencers is socially acceptable as it is not regulated by the SEC. Tech companies and US corporations are free to openly spend billions of money in corporate lobbying among the senate, and openly challenge the judgement of the senates / judges if the results are not in their favor. 

For the China economy, rules are the tools of a government to guide the growth of the industry. The use of the law to maintain order and control by the parent supersede the free will of the child and individuals. As innovation around the tech industry far outpaced the regulations and the speed of understanding by the regulators, the government seems to be rapidly playing catch up and use direct intervention methods (Price ceiling, rule change)  instead of a market (taxation-subsidy) approach to reign in the practices that are deemed undesirable by the government. For them, the free market approach is simply a tool to generate wealth in order to further the socialist principles of the government.

2) Controversial precedent on the interventionist enforcement VS free market mechanism
The hard handed approach by the china government set a dangerous precedent on what is deemed acceptable by regulators and the government. As there is open bias in most western news channels towards the ideologically different china government, along with the different written language and cultural norms, this expectations mismatch may hamper the appetite for institutional investors seeking to allocate capital into HK/China. Although there is no way to pre-determine this, this may impair the multiples Chinese firms will trade in the future, as investors may price in a probability that the government will step in and decimate the industry

Drawing analogies for the Philip Morris example in my previous post, when U.S. regulators banned tobacco advertising, the tobacco companies became more profitable and more entrenched. What could be spend on advertising became retained earnings for the company. Incumbents became more entrenched because no one could build a new, competing brand without advertising. Similarly, Chinese tech companies that can no longer sell at a loss in order to steal market share may become more profitable. At the same time, upstarts without scale who can’t underprice won’t be able to enter the market. 

However, for the China situation, there is no way to predict if another interventionist approach may be initiated to break up the incumbent to smaller segments, like in Tencent Music case to dismantle the exclusive distribution rights moat of the company, or even the larger incumbents.

3) Areas the Chinese government targeted during the crackdown

Reducing Profit-for-education sector to non profit organizations
As a product of the Singapore education and bell curve system, I am keenly aware of the subversive direction of the education sector which is increasingly becoming pay-to-win. For households without a white collar background and proper guidance from educated parents, children from blue collar parents can hardly compete without additional resources provided. Tuition in weaker areas or curriculum head-starts prior to your peers is a great tilt to furthering your advantage. Parents are prepared to spend lavishly on education if it will give their kids a leg up. To my knowledge the current SG civil service is still using your A levels, O level L1R5, and PSLE T score as a method to judge whether the potential employee is competent or employable.

Despite guidance from the SG founding fathers to view education as a great equalizer to promote the meritocratic nature of the Singapore system, the profit-for-education system seem to be the antithesis of that. A business (or teacher) can make a lot of money selling a product that has infinite demand and zero price sensitivity, but that’s not necessarily the best thing for society. My personal experiences had led me to question whether Singapore is a good place to raise kids or retire, as I personally do not like the pressure cooker nature of our education system and society.

In the US, Cheap student loans and a high cultural value on a college education made an entire generation of US students completely price insensitive. Now, those students are getting crushed by their loan payments, suffering from a dearth of quality and well paying jobs, and possibly delaying their other life goals like marriage or having kids due to affordability issues. China seems to be aware of these problems and keen to stay away of this trap, where fallout from the one-child policy has made demographic trends ugly.

“Pick one out of two” policy on merchants.
To my knowledge Tencent and Alibaba have been using exclusionary practices among its investee and partners, and links are not usable across different platforms. Alibaba also had exclusive distribution rights among branded retailers whereby they cannot partner with other upstarts like JD or PDD. In US, the government stopped this monopolistic behavior generations ago, but China is just beginning to address it.

Extreme Price discrimination to achieve profitability
Didi, China’s Uber, which charged higher fares to older customers. Imagine if Grab charged you more for the same car and the same ride just because you were older and could afford it?

 

Conclusion
As I maxed out on my portfolio allocation limits for Tencent and my limited warchest cannot accommodate the large capital commitments to average down on August, I am forced to hold off active accumulation of this counter for the time being. The importance of sticking to portfolio allocation rules should not be compromised despite my optimism on the undervaluation of the company based on its earnings power and asset value of its investment arm. Despite the fact that the CCP formalized in writing the intent to uphold the rule of law and IP rights in their white paper, there could always be the remote risk of the government overwriting it and violating Tencent's ownership of IP rights, breaking up the company or upending the founder / management based on socialist rationales.

While revisiting my China tech sector thesis via rereading through the CCP 5 year plan / white paper <Socialism with Chinese characteristics>, I noted there is significant effort directed by the government to investing in deep tech beyond <Ecommerce and gaming>, into areas such as quantum computing, photonics and semiconductors chips and electronics, network communications, artificial intelligence, biomedicine, modern energy systems. Also, despite my earlier wariness of Alibaba and its complex accounting and corporate structure, there are certain prominent value investors whom did their parallel research and haven been averaging down on the company. I look forward to checking out Baba's quarter earnings on 03 Aug before I initiate my positions in the ETF.

 I am not quite ready to take an active position on Baba but I am more open to increasing my exposure via the Hang Seng Tech ETF to the cloud computing and e-commerce arm, especially since valuations of the sector corrected significantly. There are interesting sectors that are also a beneficiary of the white paper such as clean energy generation and distribution (BYD), self driving cars and camera parts (Sunny optical), huge demand of cheap handsets in India in developing markets (Xiaomi), fast deveopments in the semiconductor space (SMIC), and telemedicine (JD Health and Alibaba Health). As I am painfully aware that I don't know when the market will bottom out, I will gradually average down until I hit my portfolio allocation limits.