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July 2021

Key takeaways:

Chinese equity markets crashed in July as a result of a decision made by the Chinese government to crackdown on the for-profit education sector, and more specifically the after-school tutoring sector. All companies offering core subject courses are required to become non-profit organisations. They can no longer raise capital through equity markets and can no longer use Variable Interest Entity (VIE) structures that were designed to circumvent Chinese laws that have always declared education as being off-limit to foreign equity investors. This is part of a wider goal that aims at boosting the dwindling fertility rate of the country and reverse the trend of an ageing population. People aged 60 and above represented 18.7% of China’s population in 2020, compared with 13.3% in 2010. This worrying trend could prevent the leadership from reaching its goal of doubling the country’s GDP between 2020 and 2035.

Around the same time, we saw the government cracking down on the abusive employment conditions of Meituan, China’s largest meal delivery platform, as well as on the exclusivity imposed by Tencent Music to its providers of music and video content. It also cracked down on the use of private data by Didi Chuxing (the Chinese equivalent of Uber) right after it went public through an ADR listing in the US. This was perceived in the western media as an attack on capital markets, as an abuse of power by the Central government, and even as some kind of revenge on US investors within the context of the current US-China tensions.

This could not be further from the truth, in our views.

The Chinese government is using the tools it has at hand, which admittedly western democracies do not have, to rectify the course of its ship. It realised it was at risk of missing its targets due to a lack of appropriate regulations. It allowed certain companies to build dominant positions and take advantage of it at the expense of the public good. It is specifically targeting companies and sectors that represent a systemic risk to the financial system (as was the case of Ant Financial), that abuse their dominant positions (Meituan, Tencent and Alibaba fell under new anti-trust regulations), that represent a social risk (this would cover Meituan and the privately-run education sector), that are a threat to national security or that pay little attention to data privacy (Didi, Tencent, Alibaba, Ant Financial and all internet platforms with more than 1 million customers have been, or will be from now on the systematic target of investigations).

Despite most of the targeted companies having raised capital in the United States through ADRs for the reason that they all wanted to circumvent Chinese laws by using offshore VIE structures (a risk that had been flagged in all IPO prospectuses), we believe it is wrong to draw the conclusion that this is a retaliatory measure against US investors. But it appears that the Chinese government did not anticipate the impact their decisions would have on financial markets, and not only on ADRs. All Chinese equity markets crashed in July. The MSCI China was down 14.1% when the CSI300 index that tracks A shares was down 7.9%. The government was so surprised by this widespread correction that it convened at short notice a meeting with investment bankers from mainland China, from UBS and from Goldman Sachs to assess the situation.

We are quite certain that the heightened market volatility will not push the leadership to soften its approach to reforms as financial markets have never influenced China’s policies, be it monetary, fiscal, social or otherwise.

Looking ahead, we believe the reforms and crackdowns of July were justified by the greater good of the country, as painful as it was for equity investors that got indiscriminately hit. We believe that going forward, the leadership’s objective is to build a more equal society, hopefully with more babies around as the cost of raising children will go down. The flip side of the coin may well be a growth rate falling short of expectations, lower margins for those internet companies that thrived on their monopolistic positions, and higher manpower costs for the service industry. We also anticipate property prices to stabilise, if not to come down.

From a portfolio management perspective, we need to identify where opportunities are. To do so, we need to put ourselves in the Chinese government’s shoes and understand what its long terms goals are and identify inflection points when they appear. One of them for instance is the recent shift towards manufacturing that had been neglected over the past years in favour of the service industry (including the internet). We believe the priority has changed since the start of this year, the trigger point being the race to technology independence.

 

PORTFOLIO REVIEW

The Chinese equity markets went through one of the most significant turmoil of recent years. The intra-month correction of the MSCI China index at some point was more than 18%, comparable to March 2020 when the Covid 19 outbreak hit the markets. Even though the index rebounded a bit in the final days of the month, investors remain jittery, facing a confidence crisis unseen for a long time. As mentioned in the above section, the market nervousness has a lot to do with misinterpretations of the Chinese government’s intention. Understandably though, for those who focus on investing in big benchmark names and hot sectors such as internet platforms, fintech companies, property management services, and online and offline education/after-school tutoring, losses are particularly harrowing.

We at JK Capital have learned over the years how important it is to avoid industries and businesses that are or are about to fall under strict government scrutiny. It certainly helped our funds outperform in July and over the past few years. We exited the Chinese education sector in 2018 and sold our last Chinese property developer holding last year. We never invested in pure fintech or property management companies. We trimmed internet-related exposure in different funds before and after the Ant Financial IPO fallout. We exited Tencent and Alibaba for the LF JKC Asia equity fund in January and sold the remaining small positions we held in both names in the LF JKC China equity fund this month.

In a recent Bloomberg article discussing about passive funds’ exposure in China, the author wrote: “Of course, to experienced emerging-market investors, volatility fueled by the Chinese government is nothing new… you can avoid the worst losses, if you are prepared or can move fast. That hands a potential advantage to active managers.” We agree with that view. At JK Capital, our equity team focuses on bottom-up research, analysing company and industry specifics under the big picture of the country’s development stage. We are constantly assessing the overall market risks and sector-specific environment changes and we choose what we deem are the best companies in the most promising industries. The fact that we run highly concentrated benchmark agnostic portfolios also means we can afford to avoid some big sectors when we see appropriate, unlike passive funds and Exchange Traded Funds.

CHINA PORTFOLIO

La Francaise JKC China Equity saw its NAV per share drop by 12.0% in July when the MSCI China Free index dropped by 14.1%. The cash position of the fund stood at 10.9% at the end of the month. Year-to date, the fund is down by 0.2% when the MSCI China Free index is down by 13.0%.

Our transitionally high cash level contributed the most to the outperformance during the month. Our lack of Meituan that went down 33% with an average 4.2% index weighting was the second biggest contributor. Techtronic Industries, going up 2.3% with a 4.3% average weighting, followed by SITC, going down only 1.5% with an average 4.9% weighting and our lightweight exposure to Tencent also helped. On the negative side, C&S Paper was the biggest drag, as it dropped by 29% with an average 5.3% weighting. On C&S Paper we realised we overlooked some important clues that indicated some management style changes. It is a mistake the manager made. We are thus reducing our exposure as we are no longer convinced of the management quality, which was a crucial part of our investment thesis.

Bilibli, an internet content producer, went down 30.4%, which also hurt us a bit but not that much as we had started to take profit in this name in February after the stock tripled since our entrance. We exited our last 1.9% exposure this month. We still like Bilibili’s competitive edges, but we believe content producers in the internet space using VIE structures will be under even stricter inspection by the government. We reckon it was prudent to exit entirely before anything specific happens.

Aside from exiting Tencent, Alibaba and Bilibili, other major trades we did include buying into a basket of five new names coming from our own watchlist: two semiconductor companies, Naura Technology and Sanan Optoelectronics, one smart grid hardware and software provider, Nari Technology, a manufacturer of Heating, Ventilation, Air Conditioning, and Refrigeration (HVAC&R) components for consumer goods and cars, Zhejiang Sanhua Intelligent Controls, and China Meidong Auto, a car dealer. We have been searching for the right names to embrace the semiconductor industry rise of China, the global New Energy Vehicles trend and China’s green energy push. These news names fit the bill. We are mindful of high valuations in these fields and will take our time to build up the positions and control the overall risk exposure.

On the news front, China Resources Beer announced a positive profit alert, expecting reported net profit to grow by more than 100% YoY for the first half of 2021. Adjusting for one-off gains and provisions, the core net profit of the company is expected to expand by more than 30% YoY. Yum China, the KFC and Pizza Hut China operator, announced results for the second quarter of 2021, with adjusted net profit growing by 36% YoY to USD185m. Sales grew 29% YoY during the quarter, while same-store sales rose by 5%. Linglong Tyre announced that its major shareholder Linglong Group sold 2% of total shares outstanding of the company through private placement. Following the placement, Linglong Group still holds 42% of Linglong Tyre. We do not like this transaction and will be monitoring the group’s moves closely while analysing the impact on the listed entity.

CICC, the investment bank and broker issued a profit alert during the month. As per the company disclosure, CICC estimates its 1H21 net income to be in the range of RMB4.4bn to RMB5bn which implies an YoY growth between 45% and 65%.

BOC Aviation issued a profit warning suggesting the group’s net income for 1H21 should be 20% to 25% lower than its 1H20 earnings. On a sequential basis, this implies a profit growth of 43% to 53% between Q1 and Q2 2021.

ASIA PORTFOLIO

La Francaise JKC Asia Equity saw its NAV per share drop by 6.2% in July when the MSCI Asia ex-Japan index dropped by 7.8%. The cash position of the fund stood at 6.5% at the end of the month.

Year-to date, the fund is up by 6.0% when the MSCI Asia ex-Japan index is down by 2.7%. 

Top attribution contributors were Indian Energy Exchange, up 14.8% with a 4.4% average weighting, and Poya, the Taiwanese retailer, up 9.6% with a 4.4% average weighting. Our lack of exposure to Tencent and Meituan that went down 18% and 33% with respective 5.4% and 1.7% weightings in the index also helped. On the negative side, C&S Paper, with an average 4.1% weighting, went down 29%, Bank BTPN Syariah (BTPS) in Indonesia, with an average 3.9% weighting, went down 17.5%, and Hangzhou Tigermed, with an average 3.3% weighting, went down 18.5%. As for trades, we continued to buy Shandong Linglong Tyre. We took some profit on AIA, Li Ning, Xinyi Glass and SITC. We also significantly cut C&S Paper as explained above.

On the news front, Indian Energy Exchange reported its 1Q22 results. Electricity volumes traded grew by 43% YoY and revenues grew by 27% YoY. Overall net income posted a strong 48% YoY growth during the quarter. Still in India, Aavas Financiers reported its 1Q22 results. Loans grew by 20% YoY, in line with its long term guidance despite a weak operating environment. Pre-provision operating profits grew by 33% YoY. Profits before tax grew by 19% YoY as provisions increased by 180% YoY.

In Indonesia, micro-credit bank BTPS reported that its loan book grew by 15% YoY and 4% QoQ while net income grew by 89% YoY with a decline in provisions.

In Taiwan, Chroma ATE reported 2Q21 results. Revenue went up 16% YoY thanks to the impact on the company of a solid demand for electric vehicles (EV) globally, but there has been some delays in the shipment of semiconductor testing machines. The company guided strong orders from EV testing solutions thanks to a strong capacity expansion in Europe.

The information contained herein is issued by JK Capital Management Limited. To the best of itsĀ  knowledge and belief, JK Capital Management Limited considers the information contained herein is accurate as at the date of publication. However, no warranty is given on the accuracy, adequacy or completeness of the information. Neither JK Capital Management Limited, nor its affiliates, directors and employees assumes any liabilities (including any third party liability) in respect of any errors or omissions on this report. Under no circumstances should this information or any part of it be copied, reproduced or redistributed.

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