In a global integrated economy and with Naspers/Prosus being a significant part of the JSE, it is important to understand what recently happened in China, what has changed, and what this means for investors. Nigel Barnes chatted to Claude van Cuyck who manages the Denker SCI* Equity Fund and Denker SCI* SA Equity Fund to ask him about this. Listen to the episode of our podcast, or read the transcript, below.
Nigel Barnes
Hello, and welcome to the Denker Capital podcast with me, Nigel Barnes. Today is the 31st of August, 2021. I’m joined by Claude van Cuyck, the head of South African equities in the Denker Capital team. Claude, I know there’s a lot to go through today. If you look around the world, the economies of the US and China dwarf other nations. So, when there is something significant from a regulatory perspective, this has a knock-on effect on everybody worldwide.
Today we want to focus on China and some of the regulatory changes that have been happening there recently and the impact on South African businesses. Claude, welcome. Could you give us a bit of background to what’s actually happened, break that down for us?
Claude van Cuyck
Sure. Thanks Nigel. So obviously, in recent months, we have certainly seen an acceleration in the intensity of regulation in China, but more specifically, they’ve targeted the technology sector. This is having a fairly significant impact on companies such as Alibaba, Tencent, JD.com and NetEase. There’s a list of technology companies that have really been negatively impacted by a lot of the regulatory noise that we’ve seen coming from China. Because these companies are so dominant now, it’s led to increased risks in the economy. And this is because a few companies are becoming extremely powerful. They’re having greater influence on society, and this is certainly making the Chinese Communist Party a lot more uncomfortable. And because of this, we’re seeing the extent of the crackdown. This is not the first time that the Chinese government have influenced sectors in the economy. They clamped down on the telecommunications sector in the early two-thousands. And then again on the banking sector around 2008 and 2009. And in both instances, they had a fairly significant impact on the returns that these sectors were able to generate. So they forced the telecommunication sector to reduce tariffs. While at the same time increasing investment in infrastructure. They forced the banks to reduce fees over time. So this, although being very good for consumers and the economy in general, it has not necessarily been that great for shareholders, and in a similar vein, we’re seeing some of those pressures being exerted on the internet and the technology sector today. So there’s no doubt that the current clampdown on the technology and internet sector all result in lower profits. It will result in lower returns for investors, but we should also be reminded that this is not necessarily a China issue. It’s a global issue. The US government is also putting a great deal of pressure on the likes of Facebook, Google, and some of the other large US tech and internet companies. This all relates to the protection of personal information, increased levels of sensitivity around data security, and anti-competitive behaviours as bigger companies are becoming more and more dominant.
Nigel Barnes
Sure. Okay. Thank you. I think that’s great in terms of the background. Maybe we can drill down a little bit now into the detail and how that’s potentially affecting some of the businesses that you look at on a day-to-day basis.
Claude van Cuyck
Sure, absolutely. There are four key areas that the Chinese government is focusing on from a regulatory point of view. I’ll also allude to the impact that might have on South African investors or those invested in the likes of Prosus and Naspers via Tencent.
1. So the first of the four key areas relates to antitrust or anti-competitive behaviours. So the large platform businesses like Alibaba and Tencent are becoming hugely dominant in China. So if you think about this, Tencent has approximately 1.2 billion people active on their social media platforms. In a sense, they are crowding out small and medium enterprises, which is the concern from a governmental point of view. They want these platforms to be a little bit more open to competition to reduce their dominance. In particular, if you look at Tencent, they’re very dominant in music in media, entertainment and gaming platforms. So the government is putting a lot of pressure on these companies by forcing them to reduce the exclusive rights and content rights attached to these platforms. If you think about the dominant position they have now in terms of FinTech, you can understand that the government is also concerned that this could pose systemic risks to the banking sector. In that regard, they’ve forced these companies to increase their regulatory capital requirements and ensuring that they don’t disintermediate the traditional banking sector. So antitrust is the first of the four critical areas that the government is clamping down on.
2. The second key area is what the Chinese government refer to as common prosperity. So, the concept of becoming wealthy together. This is clearly a function of being more of a socialist state, so greater emphasis on social responsibilities for these companies. Many middle-class citizens are being squeezed by higher mortgage costs or high mortgage payments, higher healthcare costs and spiraling education costs. And because of this, we saw a huge crackdown on the education sector more recently and they effectively nationalised the education sector. So from an investment point of view, clearly we need to think very carefully about exposures and the risks and where we are allocating capital. This is also putting a lot of pressure on companies in China to focus on their employees. For example, food delivery companies need to increase salaries of the delivery employees. They need to provide commercial work injury insurance. There’s also pressure on companies to increase social security payments like housing, pension benefits and medical aid benefits. So that is the second area where there’s pressure to basically ‘share the love’ amongst small- to medium-sized enterprises and the rest of the population.
3. The third area is teenager protection. So teenagers now are spending a disproportionate amount of time on social media (up to four to five hours a day). And the government clearly wants to control this. So we should expect further measures to limit the amount of time that teenagers will be allowed to spend on these social media platforms. And in addition to that, the amount of money that they’re spending on the platforms. In fact, we saw a few additional announcements overnight. Now, this certainly has a direct impact on the likes of Tencent. Tencent has also announced that they’ve stopped monetising minors under 12 years old and they’ve cut the amount of time that teenagers under the age of 18 may spend on gaming platforms to no more than one hour per weekday. That does have an impact on the ability to monetise and will have an impact on the returns. But to put that in context for Tencent, which is important for us as investors in Naspers and Prosus: the gaming revenues that come from under 18-year-olds is less than 6% of the total revenue. So yes, it is a factor, but it’s not that significant.
4. The final comment I’ll make in terms of these four key areas they’re clamping down on is data security. So as you can understand, there are enormous sensitivities around national security and consumer privacy protection. So China’s regulatory body recently passed a personal information protection law, which will become effective from the 1st of November. And they’re targeting, data collection and analytics. So, how does this affect internet companies? It affects them because the way they use personal information and the way it’s shared is likely to impact their ability to monetise and generate revenue. So consumers can effectively opt-out, which means that internet companies won’t be able to use their data, which will impact advertising revenue. So this is a factor for Tencent as a reasonable proportion of their revenue comes from advertising so we need to be mindful of that. And if you think about this data security issue, we recently saw the listing or the IPO of a company called DiDi, which is a ride-hailing business, similar to Uber in the US. DiDi highlighted during the listing process how fantastically they were able to use data – indicating that they could basically track down government officials and government employees and identify when they’re moving and where they’re travelling. So not a very smart move on their part. So you can understand that the government has clamped down on this. And finally from a data security point of view, government is forcing state-owned enterprises now to move data out of Alibaba and Tencent cloud businesses into a state-owned cloud business. And that’s another area that is essential for both Alibaba and Tencent.
Nigel Barnes
Okay, great. Thanks. So antitrust, common prosperity, teenager protection and data security. The listeners like me who have teenage children might not think that the teenager protection legislation is necessarily a bad thing.
Finally, the impact on things from an investment perspective – how does this change your thought process? Could you give us some background in terms of managing the portfolios?
Claude van Cuyck
In summary, I think what’s important to highlight is that undoubtedly these regulatory pressures will impact the level of profitability of the companies in one way or another – be it affecting margins or impacting certain revenue streams, which ultimately will put pressure on the return on invested capital and return on equity. This will impact the valuation outlook for the companies. So we need to understand that, we need to review our sensitivities around this and how this could impact Tencent and what has already been priced into the Tencent share price because that has a direct impact on your view on Naspers and Prosus. So we’d be naive to think that it’s not going to have a negative impact. But that’s our job – we need to factor this in. We need to understand how it might impact ratings and our view of the company over time. But, as I said, in the introduction, let’s not forget that this is not a China-specific issue. It is a global issue that investors need to think about. It’s just that I think China is taking the lead on the intensity of the regulation at this point, but there will be more to come.
Nigel Barnes
Claude, thank you. Our time is up. As you say, this is something that needs careful attention. There is more to come, and in the fast-moving world we live in today, I’m sure there’s going to be a lot more of this as we move forward. So let’s pick this up again next time we chat. Thanks for your time, and thank you for listening.
If you have any questions, please contact me at nigel@denkercapital.com
Nigel Barnes
*Sanlam Collective Investments
Disclaimer
The opinions expressed in this podcast are those of the participants and do not necessarily represent those of Denker Capital. This podcast does not take the circumstances of a particular person or entity into account and is not advice in relation to an investment. Please do not rely on any information without appropriate advice from an independent financial adviser. The value of investments may go down as well as up, and past performance is not a guide to future performance. Denker Capital is an authorised financial services provider in South Africa (FSP number 47075).
