Investing in China: Catching the Falling Knife

Investing in China: Catching the Falling Knife

The first quarter of the year 2022 has just ended, and it was time for me to revisit Chinese stocks and decide whether to finally buy the stocks or postpone the decision by another quarter. The Chinese stock prices have been falling since October 2020, for about one year and a half now, and my biggest worry was the most catastrophic outcome that could happen to a stock—getting delisted from the US stock exchanges entirely. There were rumours of this potentially happening, but when the Securities and Exchange Commission (SEC) announced the first five Chinese companies at risk of delisting last month (March 2022), I almost gave up investing in Chinese stocks altogether. Fortunately, just yesterday, good news broke out saying that Beijing is preparing to give US regulators full access to auditing reports for most of the 200-plus companies listed in New York. That was a clear sign for me from the Chinese government that they still support foreign investors from the West to invest in Chinese companies actively. I feel much easier buying and holding Chinese stocks for years to come.

How did the falling knife begin its fall?

If there is one thing China has done remarkably is to let go of the old communist inferior economic models and embrace the free markets. This allowed companies to do everything quicker: start up, sell, market, and scale, giving birth to:

  • Internet conglomerates like Tencent and Alibaba
  • Food delivery app Meituan
  • Ride-hailing app Didi

However, the Chinese regulations were lagging way behind the West while the companies experienced rapid growth at an unprecedented rate. Naturally, the powerful conglomerates started doing what all greedy businesses do: monopolise and take advantage of the smaller companies. At the same time, an outspoken CEO like Jack Ma began to openly criticise the Chinese establishments, which sounded more like challenging political statements. So the Chinese government took matters into its own hands in 2021.

  • Jack Ma got kidnapped for "questioning."
  • Regulators halted the IPO of Alibaba subsidiary Ant Group and left its public reputation in tatters.
  • Regulators took aggressive steps to rein in anticompetitive behaviour by issuing a record $2.8 billion fine on Alibaba and a $530 million fine on Meituan.
  • Regulators increased penalties for antitrust violations.
  • Regulators launched a new anti-monopoly bureau under State Administration for Market Regulation (SAMR) to enforce it.
  • Regulators passed the law to make data privacy more strict, which disrupted Didi's planned IPO in New York for failing to comply.

China's "common prosperity" mantra did not stop with just the tech companies, and the government also saw the unfairness in the education and test-prep industry. China has an intensely competitive education system where students bet their lives on the make-or-break high school and university entrance exams. Because of such an environment, there are companies in China worth billions that train the students to do well on these exams. Paying for these specialised classes was a clear advantage for the students who could afford them over the ones who could not.

  • Regulators banned all for-profit tutoring for the entrance exams, practically driving the multi-billion dollar revenues to zero overnight.

All of this happened in the last year, and it was as if Beijing prepared its ammunitions on a machine gun and rapidly fired all in one go. To put the aftereffect of this in perspective, we are witnessing an average of -75% drop in Chinese stocks, much worse than the -50% drop in US stock markets in 2008.

Why buy the Chinese stocks?

When the prices of the stocks collapse in a significant way like this, it often grabs the attention of the value investors. Warren Buffet's long time partner, a legend in his own right, Charlie Munger, revealed his purchases of Alibaba shares to hold for the years to come.

His reasoning, in a nutshell, is as follows:

  • Chinese government's commitment to free markets is serious, and as long as they allow the businesses to flourish again, their economy will bounce back up.
  • Chinese economy needed a correction. He admires just how efficiently the government can act and take control of the mess.
  • The fundamentals of the Chinese large-cap companies are still solid, with large cash reserves.

What are the risks?

  • In 2022, Ukraine vs Russia war has upgraded geopolitical indicators as the primary. Chinese stocks will fall more if China sides with Russia, which risks being economically sanctioned by the western countries.
  • COVID is still rampant in China, and the economy will continue to experience low growth due to the past lockdowns and the potential ones in the future.
  • Nobody knows when the Chinese regulators will ease up to let the companies breathe again. If they continue to tighten their regulations, stock prices will inevitably fall more.
  • Chinese companies are not fully transparent. As mentioned at the beginning of this post, they will be more transparent than now soon, but it's still up in the air.

Word of caution to those investing

After being incredibly patient with Chinese stocks, I am finally pulling the trigger to buy XCS6, an ETF consisting of large and medium cap Chinese stocks. Since this ETF includes medium cap companies, it will be higher risk, more volatile, but more returns. A safer alternative would be FXI, an ETF that consists of only large-cap companies. The three main reasons that allowed me to make this decision are:

  • The Chinese government is committed to supporting free markets.
  • The Chinese government confirmed to allow foreign investors to continue investing in its companies.
  • The prices of the Chinese stocks are at a low, discounted price. It's time for me to start buying when there is blood on the streets.

When risking catching a falling knife like this, you must be very careful to only invest no more than 5% of your portfolio without leverage and be willing to hold for many years.

← Guides