By Randall Coleman, Portfolio Manager
US traded China ADRs were dealt a severe blow last week by regulators on both sides of the Pacific, causing a dramatic and uneven loss of value in China-based stocks. The brunt of the damage came from the for-profit education industry in China, where regulators have mandated companies move to a non-profit structure. Casting a further pall on the industry, China banned private education firms from going public or raising capital. From the other side of the ocean, US regulators—the SEC—proposed new disclosures from Chinese companies, essentially blocking new listings. This double whammy begs a few questions: Why would China lay down rules that obviously harm an industry? What is behind the SEC’s demand for a higher level of scrutiny? Finally, and probably the most fundamental question: Is any exposure to Chinese companies warranted?
To begin, historically, the case for ADRs in value creation has been unequivocal. (As a reminder, ADR stands for American Depository Receipt. They give US investors access to foreign equity markets via US traded securities and similarly provide a potential vehicle for foreign companies to raise capital in the US.) According to one study, Chinese and Global ADRs: The US Investor Experience (Financial Analysts Journal, Vol 77, 2021 – Issue 3, pp. 53-68), ADRs have created over $1 trillion in wealth between August 1954 (when the first ADR began trading) and September 2020, with more than a third of that value coming from Chinese firms. The study goes on to point out a performance advantage in a value-weighted portfolio of Chinese firms of 4.2% per year versus the overall US stock market since the first Chinese ADR was created in 1993. ADRs, and Chinese ADRs in particular, have benefited US investors dramatically. With careful selection, we see this record of value creation continuing in the future.
So, what’s behind China’s obviously detrimental moves? It is painfully clear that China will sacrifice select investor interests to further its social objectives. Intense competition for admission to high schools and universities has led to a vast industry in tutoring and coaching Chinese students vying for these prized spots. As the industry grew apace, the government took notice of its profitability and burden on consumers. In an effort to rein in spiraling costs, regulators pulled the profit rug out from under the industry. Removing profit is clearly a direct way to control costs in the education industry. The “social good” of cost control outweighs the “social good” of a for-profit education industry. The lesson to investors is to maintain a business in alignment with government planning.
Turning to the US side of the equation, what is behind the SEC’s onerous moves? To give some background, an explanation of a VIE—Variable Interest Entity—is required. VIEs are shell companies that participate in an underlying company’s profits via contract, not direct ownership. VIEs were created to circumvent Chinese rules that prevented foreign ownership of mainland companies. They are a loophole that has led to some incredible success stories and wealth creation as well as some incredible stories of fraud, deceit, and wealth destruction. The typical route to US investors for VIEs has been through ADRs. While ADRs typically represent a specific number of shares in the foreign company, in the case of VIEs, they represent ownership in the shell company that simply has a contract with the mainland-based company. Because there’s no direct ownership of the underlying company, VIE participants have no ability to audit or inspect underlying financial records. This is of grave concern to the SEC.
A potential path forward where the VIE loophole is closed is already up and running. The Hong Kong stock market is the gateway to China and is becoming more integrated with China’s mainland markets—Shanghai and Shenzhen—every year. Through Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect, Hong Kong and foreign investors can trade stocks listed in Shanghai and Shenzhen Stock Exchanges (“Northbound Trading”) while Mainland investors can trade SEHK securities (“Southbound Trading”). Hong Kong Stock Exchange’s financial reporting requirements are superior even to US reporting requirements. Should Hong Kong listings or Hong Kong-traded securities take the place of VIEs, we would regard that as a distinct improvement over the current situation.
China has been liberalizing and opening its financial markets to the world since 1979, when they lifted the ban on entry of foreign banks. In 2001 the country joined the World Trade Organization (WTO) and a new phase of super-charged growth ensued. Ten years ago, there were 400 foreign banks operating in China. Two weeks ago, state media reported the cabinet saying “China will continue to open up its financial sector and improve rules for foreign banks and insurance firms entering the market.” As China’s imports and exports continue to grow (see chart), the country seeks further access to foreign capital. Opening its financial sector is a necessary means to that end.
The writing on the wall is clear: China is clearly in a mode of opening its capital markets and US investors benefit from participation. Utilizing the Hong Kong exchange as a conduit for that growth makes logical sense from both a regulatory and logistical perspective.
As ACM’s Dr. JoAnne Feeney pointed out in her Bloomberg interview on Friday, some Mainland based companies are core to the country’s recent economic boom, enabling the growth the government desires. Firms aligned with China’s goals—those in Cloud services and technology and affordable retail to highlight two areas—will continue to thrive.
Talking to the big picture question, is any exposure to Chinese companies warranted? We firmly believe the answer is yes.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.