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Should we be wary of Chinese stocks?

09/13/2021 | 11:22am EDT

There are many risks and uncertainties hanging over Chinese stocks. The proof is that the Hang Seng Tech index, which includes Chinese technology companies, has lost nearly 20% of its value since the beginning of the year. Governance risks weigh heavily on the Chinese market. However, they are not the only reason for this poor performance. There are actually three major risks. Let's take Alibaba as an example which perfectly illustrates this analysis. However, these risks apply to most Chinese companies, technology or not.

1- Risk linked to the deployment of an anti-monopoly policy:

The first but also the major risk related to Alibaba is probably the Chinese Communist Party, which is becoming increasingly oppressive towards mega-cap companies. The central rule of the CCP is that the state must never lose control over the private sector. Nothing changes or moves without its approval.

In order to achieve this goal, the Chinese government sometimes uses its power to influence the economy and therefore the markets. It is therefore, as you can imagine, very complex for a company like Alibaba to go under the CCP's radar. Even more so when its founder is openly critical of the Chinese banking and financial system. And in such cases, the government's reaction is not long in coming and serves as an example. In the case of Alibaba, the IPO of Ant Financial, a subsidiary of Alibaba, was blocked by the government only a few weeks later. But what worries the markets more are the anti-monopoly laws that China has been putting in place for some time. Recently, Alibaba was fined $2.75 billion (2.5% of 2020 revenues) for abusing its dominant position for several years.

If these laws exist everywhere in the world, it seems that they are more worrying in China. In particular, foreign investors are afraid that Alibaba will be dismantled as it could potentially grow too big and wield too much power, which has worried the government in its quest for total control. Reading the CCP report, the fine seems more or less understandable, at least based on tangible evidence.

"Since 2015, Alibaba Group has abused its dominant market position by prohibiting merchants on the platform from opening stores or participating in promotional activities on other competing platforms."

PCC report

Admittedly, this is indeed anti-competitive. To sum up, China seems to be mostly implementing new rules to better control its economy. Anti-monopoly laws exist all over the world, as evidenced by the ongoing lawsuits against Apple and Microsoft in the USA, Europe, South Korea, etc. Indeed, China is going strong. Even if it means sacrificing sectors of its economy, as it did a few weeks ago when it forbade the for-profit education industry to make a profit.

But one thing is certain, the CCP is very happy that Alibaba exists. The e-commerce giant has helped China's development enormously and plays a very important role in the economy. By 2024 Alibaba is expected to have more than one billion Chinese customers resulting in $155 billion in transaction flows on the platform. Now, it is quite possible, although extremely unlikely, that China wants to destroy Alibaba. But we have to ask ourselves whether it is really in the CCP's interest to bring down one of the country's most important companies and a major symbol of Chinese soft power. As Mohnish Pabrai points out, Alibaba is one of the jewels of the Chinese economy. These companies can play a central role in the global economy of tomorrow. The government has little interest in sacrificing a company like Alibaba, which has brought in 7.7 billion dollars in 2019 to the State via all the contributions and taxes. Moreover, thanks to its ability to facilitate trade in China between merchants and consumers, Alibaba has surely generated billions of dollars, which will also be taxed.

But let's be cautious, China has recently stated that in the next five years, in addition to strengthening anti-monopoly laws, it wants to tighten regulations on finance, the internet, big data and the cloud. These regulations are currently non-existent and will all have an impact on Alibaba. The risk premium on this stock is therefore very high and the stock price could still suffer in the coming months/years before recovering.

Source: Marketscreener

The second risk is a risk of accounting fraud. Some investors do not trust the figures of Chinese companies which, like the CCP, can sometimes be dubious and obscure. However, Alibaba, being listed in New York, produces its accounts with the accounting principles generally accepted in the United States and has had them audited by PWC for over 20 years. PriceWaterhouseCoopers (PWC) is considered one of the four largest accounting firms in the world, operating in 157 countries and employing about 284,000 people worldwide. It is nevertheless possible that Alibaba's management team falsifies its figures in agreement with one of the four largest accounting firms in the world, but the likelihood of this remains a priori remote. However, it is important to note that Alibaba has never been inspected by The Public Company Accounting Oversight Board as the Chinese government prohibits this type of inspection for Chinese companies, and their audits. As a reminder, the PCAOB is a private, not-for-profit corporation established by U.S. law in 2002 to oversee audits of publicly traded companies in order to limit accounting abuses and irregularities in publicly held companies.

Top global audit firms in 2020, in millions of dollars of revenue

3- Risk of delisting from the NYSE:

What about Alibaba de-listing from the New York Stock Exchange? To answer, we need to understand how Alibaba is structured.

To buy Alibaba shares, there are three options:  Hong Kong, New York or Frankfurt. For the last two you don't actually buy Alibaba shares but you buy shares in Alibaba Group Holding Limited. This is a variable interest entity (VIE), and owning shares of a VIE certifies ownership of a contractual right to a percentage of a company's profits. Unlike a traditional stock, a VIE stock confers a legal ownership interest in the assets of a completely separate company (sometimes called a shell company). In the case of Alibaba, shareholders holding BABA shares listed on the NYSE, hold an interest, through American depositary shares, in Alibaba Group Holding Limited, an entity registered in the Cayman Islands. It is under contract with Alibaba to receive profits from lucrative Chinese assets. BABA's shareholders have no ownership interest in the assets of the China-registered Alibaba company, only its profits. A VIE therefore protects a company from being sued by its creditors. But Alibaba did not create a VIE for this sole reason. The Chinese government does not like foreign ownership in its economy and has banned it. So, Chinese companies were forced to set up these foreign entities in order to facilitate their access to foreign investors. In this way, you still buy shares of Alibaba but you do it through a foreign entity.

Sources: ZoneBourse

The problem is that to be listed on the NYSE, foreign companies must prove that they are not controlled by a government and must also audit their accounts by a firm certified by the PCAOB. And this is a potential problem since the Chinese government prohibits the PCAOB from conducting inspections of Chinese companies and their audits of US companies. This will have to be resolved within the next three years, as otherwise the New York-listed version will be withdrawn. De-listing from foreign stock exchanges (NYSE and Frankfurt) will not result in a loss of your shares. It simply means that these shares will be traded over the counter, but there is no doubt that this would have a strong influence on stock prices. In addition, institutional investors would be forced to sell these shares as legal rules do not allow for the holding of OTC shares. The significant outflow of capital from institutional investors would therefore lead to an even greater fall in share prices. Buying stocks listed in Hong Kong will protect you from the risk of de-listing but not from the negative impact of this potential measure on the stock price. Regardless of your Alibaba shares, this is a risk to consider.

ę MarketScreener.com 2021
Stocks mentioned in the article
ChangeLast1st jan.
ALIBABA GROUP HOLDING LIMITED 0.35% 171.0355 Delayed Quote.-26.96%
APPLE INC. -0.45% 148.689 Delayed Quote.12.53%
HANG SENG -1.54% 25620.85 Real-time Quote.-4.44%
MICROSOFT CORPORATION 2.98% 319.57 Delayed Quote.39.43%
PINDUODUO INC. 0.14% 93.565 Delayed Quote.-47.55%
TENCENT MUSIC ENTERTAINMENT GROUP 0.37% 8.075 Delayed Quote.-58.37%
VIA S.A. -6.06% 6.66 End-of-day quote.-58.79%
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