collapsing Chinese stocks: what did Xi think would happen?

Press reports indicate that earlier this week the Chinese equivalent of the SEC called a virtual meeting of global institutional money managers in an attempt to stem the continuing selloff in Chinese stocks. Officials “explained” that the latest development, the recent attack on publicly-traded cram schools was an isolated incident addressing a socially unacceptable practice, not an attempt to squelch private enterprise in general.

That might be true. And it might be believable …if this were an isolated incident. However,

–two years ago, Beijing introduced a bill in the Hong Kong legislature, a body it has complete control over, that gave the mainland the right to extradite to the mainland for trial any Hong Konger accused of a crime. This set off a prolonged series of anti-mainland protests that Beijing suppressed brutally. Subsequent trials of protestors, which are still continuing, have resulted in long prison terms for what seem to be minor offenses.

This action has substantially diminished Hong Kong’s appeal as entrepot to the mainland and as a global financial center where foreigners can buy shares in the best and brightest of China’s commercial enterprises. It has also brought greater meaning to Beijing’s declaration in 2017 that it no longer believes it is bound to its 1997 promise to allow Hong Kong a high degree of autonomy during a 50-year transition period from British rule

–last October, Beijing began an investigation of Alibaba’s apparently subversive idea of creating a fintech giant to compete against senescent traditional commercial banks, scuppering its plan to take its Ant Financial subsidiary public.

–this year, the attack spread to Alibaba’s rival Tencent

–recently, ride-hailing company Didi has come under similar pressure, apparently for ignoring Beijing’s orders not to list in the US.

The outlier here is the claim that nothing much is going on. For China, the highest official political aim is keeping the Communist Party in control of the country. To my mind, Xi is eliminating the threat from counter-culture entrepreneurs. Understandable from a narrow political perspective, much less so from an economic one.

Another thing I find odd is that from a political perspective, it seems to me that the US should be supporting the counter-culture companies. But Trump’s main thrust has also been an effort to cripple them by denying them access to American capital markets.

concept vs. valuation

Speaking in the broadest terms, we can (and should) look at a an individual stock, an industry or the stock market as a whole from two perspectives:

–why am I buying this particular thing (the concept), and

–how much should I pay for it (valuation).

Concept may start out with something a simple as an elevator speech:  “Tesla is the leading maker of electric vehicles, which are displacing conventional fossil fuel-driven alternatives much more quickly than the consensus expects.” or “Intel has stagnated for years, losing its cutting edge position as a semiconductor chipmaker. The company has valuable intellectual and manufacturing assets, however. As soon as irate investors install better management, it will return to its former glory.”

Valuation starts for many stocks with a glance at the PE ratio based both on trailing earnings and on consensus beliefs about what future earnings will be. For a potential turnaround, the first step is more likely a peak at the balance sheet and as guess at what the plant and equipment, plus any intangible assets. might be worth if they were being utilized efficiently.

The elevator speech is not an end point. TSLA is trading at 283x trailing earnings and 108x the consensus guess at 2022 results. Given that the forward PE on the S&P 500 is about 22x, TSLA seems expensive, assuming the consensus is correct. INTC, on the other hand, is trading at about 12x earnings, both trailing and forward, and yielding 2.6%. Arguably, we’re being paid to wait. Here the important question to pursue may be how long the wait is likely to be. If we had acted on the positive story at the start of 2018, we’d be up by about 10% vs. a gain of 50%+ for the S&P. Investors normally tend to find a combination of concept and valuation that works for them.

My take on the US stock market over the past 18 months or so is that this hasn’t happened. Virtually all the emphasis has been on concept, with next to none being paid to valuation. At a time when interest rates were zero-ish, with a high likelihood they would stay that way for as far ahead as investors were willing to think, this makes at least some sense. For what it’s worth, it’s also the way the Japanese market acted in the late 1980s, under similar interest rate circumstances (the only other case I’ve ever lived through).

What strikes me about the quarterly earnings reporting we’re in the midst of is that suddenly valuation seems to be back in play. Yes, MSFT (a stock I own) had a blowout quarter. But it’s already trading at a premium multiple of 35x this year’s earnings. And the analyst earnings estimate of 12% eps growth for 2022 better just be a placeholder–because it’s too close to the earnings gain the average stock is likely to put up to avoid contraction of its PE multiple toward the S&P’s (finance-speak for “the stock will go down a bunch”).

Six or nine months ago, MSFT would probably have gone up a few percent on this kind of good earnings news–maybe more. But yesterday, despite an initial blip up, the stock ended the day in the plus column by 0.1%. Yes, that’s a better outcome than many other recently reporting companies have achieved. But I still think it’s evidence of a sea change in investor thinking about stocks. It’s no longer about what companies will prosper as we’re fighting out way through the pandemic. As I see it, Wall Street is beginning to take a return to some form of normality for granted. Simply coming out the other side of the pandemic while still afloat is no longer enough. That’s already being assumed. What will separate winners from losers in today’s market is actual and anticipated earnings performance in the post-pandemic world.

To a considerable degree, PEs are determined by the price of substitutes, meaning the 10-year Treasury note. The prospect of rising interest rates will doubtless become an obstacle to be overcome by the stock market at some point in the future. Maybe there’s even a little bit of that worry in the way Wall Street is reacting to earnings reports. But not a whole lot, I think. This is a return to the normal Wall Street emphasis on tempering concept by considering valuation.

I don’t this necessarily means stocks in general will begin to trend down. It does mean, I think, that professional investors will be more cautious about bidding up a stock based mostly on an industry story or a macroeconomic trend, without satisfying themselves that there’s also solid profit growth in prospect.

blowout earnings, meh market reaction

The catchall, simplistic–but ultimately correct–evaluation of this state of affairs is that the market has already “discounted”, i.e., factored into prices, the favorable earnings information being revealed now.

What’s different about today’s situation, though, is that up until now market action has been strongly influenced by two reactive–not anticipatory–forces. One is ultra-fast-responding algorithms. The second is the stock market equivalent of social media influencers, appearing in forums like Reddit or as TV/radio presenters pretending to be veteran investors. Both are sets of people who are famous for being famous, not for being competent or knowledgeable about financial markets.

Is this a signal of a lasting change in market dynamics? If so, making money will likely be considerably tougher in the months ahead. More tomorrow.

unconventional IPOs

Going public in the US the conventional way, through a major brokerage house, isn’t cheap. The fees for underwriting and distribution will easily amount to 5% of the offering, and may end up significantly north of there. Perhaps more galling to the company going public, the stock often opens–and stays–20% or more above the offering price set by the underwriter. This gives the impression–which is also the correct reading, in my opinion–that the broker’s main allegiance is to IPO buyer. What the company also sees is an enormous amount of money left on the table.

The company that chooses this route does get something in return: the IPO roadshow, which introduces it to the investment community and the promise that an analyst from the brokerage house will cover the company, issuing periodic reports keeping institutional holders informed about the company’s progress. This isn’t nothing.

Still, these inform-the-buyer benefits are hard to value. It’s also not clear that traditional brokers have the clout they might have had before the 2008-09 financial crisis. And no one likes their offering being the vehicle for brokers to reward their highest-paying institutional customers. So it isn’t surprising that firms in increasing numbers are exploring cheaper, non-standard ways of going public.

The poster child for why this is a mistake is Google, which decided it would go public through a Dutch auction (don’t ask). The offering was a dud and the stock languished for months around the IPO price. The main reason, I think, is that Wall Street didn’t understand what Google was or why it was important. I certainly didn’t at that time. The firm I was working for did, however, and scooped up large amounts of what turned out to be extraordinarily cheap stock.

Did the big brokers deliberately not cover Google in its early days? That would be my guess, but that’s pure speculation. And going the unconventional route doesn’t seem to have hurt the company in the long run.

In today’s market, there are two unconventional ways for companies to go public: direct listings and SPACs.

The SPAC structure very, extremely, highly, tremendously tilts the odds of making money toward the organizers of the SPAC and away from you and me.

This leaves direct listings, where a company files a prospectus with the SEC and, on approval, begins to offer stock on an exchange directly to investors. No underwriting or sales syndicates, no stock price stabilization period, no follow-on outpouring of (favorable) brokerage research. Just trading.

There’s a little bit–and maybe more than a little–of Google in the process. I think this is because direct listing companies don’t know how to communicate with potential institutional buyers of their stock and don’t know how much they can say about how business is doing.

That’s the interesting part to me, because it suggests that institutional investors don’t have a built-in head start over you and me. If we do a little homework maybe the opposite is the case.

China, including Hong Kong

vanguard of the people

In the mid-19th century, Karl Marx theorized that working conditions in factories in economically advanced countries like Germany were so bad that abused workers would spontaneously rise up and throw off their chains. When that didn’t happen, late nineteenth-century activists like Lenin decided that workers needed to be pushed into action by a cadre of militant revolutionaries, the “vanguard of the people.”

China

Mao used the Leninist idea to reshape Chinese society during the second half of the last century. The vanguard in this case is the Chinese Communist Party, whose highest goal is to perpetuate itself as the source of political power in that country. Economic and social objectives were set by the Party’s central planning and disseminated to businesspeople and local/regional politicians, all of whom were Party members.

By the 1970s, the economic flaws in the central planning model were more than evident. GDP was dominated by antiquated/inefficient state-owned enterprises, which lived in an alternate universe along with government planners, in which planning targets were sensible and always met–despite overwhelming evidence to the contrary. In effect, the biggest threat to the Communist Party in China, whose survival is the country’s highest economic/social goal, came from the central planning ecosystem.

Deng Xiaoping addressed this existential threat in the late 1970s, by supporting ” socialism with Chinese characteristics.” Making a corporate profit was now permissible and Party membership and approval were not immediately necessary for entrepreneurs. A well-respected Hong Kong-based economist I knew at the time prepared two series of periodic reports for her clients back then. The content was identical. In Hong Kong, they were were called Capitalism with Chinese Characteristics”; on the mainland, however, they were titled “Socialism with Chinese Characteristics.” I think this accurately described the situation. The result was a decades-long explosion of economic growth.

Thirty-some years later, Xi Jinping faced a different set of problems when he assumed control of the Party apparatus in 2012-12.

–enough high-ranking Party officials had used their influence to make themselves and their families fabulously wealthy during the Deng era, and were flaunting their new status, that the disparity between them and ordinary citizens was becoming a deep source of popular discontent

–while the (mind-boggling, in my view) inefficiency of the industrial base during the Mao era had been addressed, the banks were still in poor shape. More than that, they had given loan support to many hare-brained, economically ruinous schemes hatched by Party elites

–some newly-minted billionaires were forgetting to give even lip service to the central role of the Party in directing the country. If press reports are correct, Jack Ma of Alibaba even openly to financial officials last year about his plan to undermine the banking system through his Ant Group; and the Didi ride-hailing group ignored Chinese regulators’ orders not to list in the US without their approval.

For what it’s worth, it seems to me that Xi is by nature an anti-Deng, a more orthodox Leninist and a promoter of politically correct state-owned enterprises. His decision to end Hong Kong’s status as a Special Administrative Region a quarter-century earlier than China’s agreement with the UK called for is, I think, an exercise in Realpolitik as well as a message that obedience to the Party is paramount. Still, one could argue that part of what Xi is doing is reining in excesses that gradually developed during three decades of laissez faire.

implications

–conventional wisdom has been that the big prize for China is eventual reintegration with Taiwan and that China would treat Hong Kong with kid gloves so that it would serve as a case study in tolerance for non-Party views. That’s out the window now. One area of strategic significance for Taiwan is the world-leading role of TSMC in chip manufacturing. This is an art where in terms of capacity the US and Europe have slipped behind Taiwan, Japan and China. This year’s chip shortage has underlined the vulnerability this represents. I’ve been saying for some time that the semiconductor manufacturing business will be booming for the next few years.

–the example of Jack Ma suggests that China-based multinationals won’t be quite as aggressively innovative as they have been in the recent past. It’s unclear how long Beijing’s current crackdown will last, nor how Chinese firms will act, post-crackdown. To my mind, this makes the publicly-traded companies harder to handicap. They’re already trading at lower earnings multiples than before, but I don’t have a strong idea whether they’re cheap now or not.

–the disastrous collapse of the Hong Kong stock market in 1987, in a brokerage scandal triggered by Black Monday in the US, led to a regulatory overhaul that has transformed it into one of the premiere listing destinations in the world. Arguably, Chinese firms listing in New York have done so because they are unable/unwilling to meet Hong Kong’s more rigorous standards.

China’s repudiation of the terms of the handover agreement and its subsequent anti-democracy crackdown in Hong Kong have removed a lot of the luster from the SAR’s stock market, as well as from Hong Kong’s viability as a regional hub where multinationals can safely open businesses. This has negative implications for the property market there as well as tourism to the casinos in nearby Macau.

It’s conceivable, though hard to fathom, that Xi has given no thought to this consequence of the crackdown. The result is the same, though. More equity raising will have to be done through the mainland Chinese stock markets.