Oliver Cox

China’s recent regulatory measures targeting internet leaders have cast a shadow over market sentiment across the technology sector. It has given investors a lot to digest, but it would be a mistake to assume that all regulations have the same motivation, or that all companies in the sector are set to be impacted in the same way. In fact, sifting through the details of what these changes mean for corporate profits will prove critical to finding Asian tech returns going forward.

Admittedly, the regulatory regime currently facing the China internet space is creating short-term headwinds, which may continue for some time, but we believe these pressures will ultimately prove to be transitory. The regulatory overhang shouldn’t negatively impact important corporate strengths such as innovation and entrepreneurship. In the meantime, the volatility these policy shifts have churned up in the short run is actually creating some attractive investment opportunities, as the stocks of some fundamentally strong companies are available at disproportionally cheap prices.

Although we are seeing an uptick in activity on the part of the Chinese tech regulators, it would be wrong to assume they are taking an indiscriminate hardline stance that will unduly penalize their technology giants. Indeed, with the backdrop of escalating geopolitical rivalry between the United States and China, it would hardly be in the strategic interest of the Chinese government to punish their domestic champions.

Rather, what the Chinese government wants to see is a fair, well-functioning and resilient industry playing field, which can allow competition to thrive. They do not want to dismantle their leading companies, but they do want to ensure that the next cohort of innovators has space to flourish.

Winners and losers

Many people assume that there is one universal approach to Chinese tech regulation. However, we believe it is necessary to take a closer look in order to discriminate between different areas of regulatory focus – which in turn enables us to distinguish between winners and losers:

• Regulators are cracking down on inappropriate usage of market power by some China internet companies, such as exclusivity agreements, which might inhibit smaller players from entering the market.
• There is a move to stop companies trying to exploit regulatory arbitrage opportunities, which might have wide or potentially destabilizing implications for other sensitive areas of the economy, for example in finance.
• Policies are being introduced to help stamp out “monopsonist” behaviour by companies, where they are acting as the only buyer in the market, in order to make markets much more robust and competitive for the long term.
• An emerging regulatory focus is around data and cyber security and therefore user data, for example in transportation apps.
• We’re seeing a decoupling in US and China company listings, with the result that more Chinese companies will list on exchanges in the Greater China region – in the process having to tap a different pool of capital.

A lot of these meaningful changes will take time for the sector to work through, but the reality is that the overwhelming majority of China’s internet leaders have been working hand-in-hand with the government for many years and will continue to do so as they chart future growth. The route through this changing paradigm will unquestionably zigzag, but ultimately it should allow plenty of runway for continued growth for many of these companies.

Focus on fundamentals

As the regulatory playing field evens out, investor attention will gradually return to focusing on the compounding of earnings and other fundamentals.

In the long run, earnings-per-share growth is always the primary determinant of shareholder returns. Market timing in the short term is all but impossible. Rather, the path to maximizing investment returns is to back good quality companies with strong growth potential and stick with them for the long haul.

Take Tencent as an example. The core of the company from its origins was as a strong gaming franchise, which remains the case today. Of course, it’s gone on also to develop leading positions in entertainment, fintech, e-commerce, and more recently enterprise software. Investors who constantly fret about its current share price are always wondering, can the company keep growing or is it now too mature?

Our clear view is that this company has massive continued growth potential, with the possibility for net profits to treble between 2020 and 2025, by our estimates. It is actively investing in its business, expanding internationally, competing for acquisitions and generally taking a bigger share of the global gaming market beyond China. Despite all this, the stock price isn’t even close to reflecting the future returns.

To provide another example along similar lines, we can look to China internet challenger Meituan, one of a new emerging breed of companies. The current leader in the domestic delivery market, Meituan is just getting started in terms of investing, growing, and building its earnings power and scale for the long run. This could lead to profit growth of up to six to seven times over the next five years. But yet again, the current stock valuation is in the doldrums, signifying the bargain available to investors willing to key their eye on the long term.

Rather than get sidetracked by the noise, long-term investors who understand the world-beating potential for Asian technology companies should keep their eyes trained on the horizon and focus on the fundamentals, which serve as a compass to guide us through this period of regulatory change.

Oliver Cox is portfolio manager of JPMorgan Pacific Technology Fund.