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BATs will not fly

Data is the oil of the 21st century and China is the Saudi Arabia of data…but recent signals from Chinese policymakers suggest that investors are unlikely to benefit as much as we originally thought. At best, we will witness the ‘bondification’ of China (similar to Japan); at worst, innovation might be stifled. BATs* will not fly.

* BATs: Baidu, Alibaba, Tencent

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China is the new Saudi Arabia of data but ... 

In 1992, I visited China for the first time as a member of my company’s investment committee. The trip took us from Hong Kong to the recently established Shenzhen Special Economic Zone and then to Shanghai. We visited about a dozen companies, supposedly the flagships of the stock market at the time. For the record, among them was an analogue taxi company. Didi and its digital booking model would be founded 20 years later, in 2012.

I returned from China convinced of the country’s development potential. There was no doubt that its gross domestic product was going to grow tremendously in the next couple of decades. However, I also came back convinced that I could put the monitoring of Chinese stocks on hold. China had no interest whatsoever in efficient capital allocation. At the time, I was busy applying the lessons from Stern and Stewart about economic profit to developed equity investing (that anomaly died in the late nineties). China did not tick the box. For 20 years, no investment committee chaired by me allocated to Chinese stocks. Events proved me right. It was all about growth by any means, even at the expense of the environment.

Some 25 years later, in 2017, Julius Baer’s Investment Committee suggested in its Secular Outlook that Chinese equities were on the verge of becoming a core asset class, separate from the more heterogeneous universe of emerging market equities. Their status was set to rival that of US equities, the ‘mother’ of all capital markets. This secular optimistic view is underpinned in particular, but not only, by the fact that the Chinese market is the only one, apart from the US, that gives rise to companies with exponential business models based on network effects and the competitive advantage of data collection. But since 21st-century China is to data what Saudi Arabia was to oil in the 20th century, the prospects of China’s digital platforms, the BATs, should even exceed those of America’s famous FAANMGs (Facebook, Apple, Amazon, Netflix, Microsoft, and Alphabet’s Google).

It should be remembered that the latter are the source of the structural outperformance of US equities over the last decade. They account for more than 20% of the S&P 500 index, or almost USD 9 trillion of market capitalisation. Their success is based on the strength of their business models, but also on the relatively accommodating attitude of US regulators, particularly with regard to the collection and use of data...

…BATs will not fly
Since February, Chinese stocks have massively underperformed developed-market stocks. There are two reasons for this recent negative development. First, the tightening of macroeconomic policy by the Chinese authorities to ensure financial stability and, in particular, to prevent excessive leverage. The second reason is the campaign to regulate digital platforms, which began with Alibaba in late 2020 and has taken on a different face with the latest decisions that hit Didi Chuxing just days after its initial public offering in New York at a price of USD 14 per share, or a market capitalisation of about USD 60 billion. The company faces an investigation on cybersecurity and the handling of consumer data by the Chinese regulator. Mobile phone application platforms have been instructed to remove the company’s app from their digital stores. This follows a long list of such regulatory strikes in the last nine months.

Beijing will not let its digital champions build a dominant competitive position similar to what we have seen in the US in recent years.

The message is increasingly clear. Beijing will not let its digital champions build a dominant competitive position similar to what we have seen in the US in recent years. Nevertheless, the country has reached a stage of wealth where efficient capital allocation is essential. However, we are sceptical about the ability of leading Chinese digital companies, whose growth potential is now limited, to return free cash flow to shareholders, even modestly compared to their US peers. The situation reminds me of my return from Shenzhen and Shanghai in 1992. In the short term though, the risk seems acceptable after the cumulative impact of macroeconomic tightening and multiple regulatory initiatives. The relatively measured reaction of Didi shares following the latest announcement (-20%) shows that the risk premium is relatively generous. In the longer term, we should consider a ‘bondification’ of China. The risk premium realised on Chinese equities this decade is likely to be less generous than we had hoped. We will return to this topic after our annual Secular Outlook update.

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