The recent blow to the Chinese equity market has been widespread and punished Chinese stocks across the board, leaving numerous stocks that trade on US exchanges in deeply undervalued territory.

The decline was instigated by a combination of slowing economic growth and rising concerns that China’s Common Prosperity Push will reduce corporate profitability. Although Chinese stocks have started to recover from a significant hit over the summer, for year to date through Sept. 6, the Morningstar China Equity Index remains down approximately 11%.

The Common Prosperity Push is a broad-based effort intended to improve social harmony in China. Jacky Tsang, a Hong Kong-based Morningstar equity analyst, explains:

“The ultimate goal is to form a more oval-shaped income distribution for the country that increases the proportion of the middle class and decreases the size of the upper and lower classes. By doing so, the greater consumption power of a larger-sized middle class would enhance the self-sufficiency of the economy by supporting local manufacturing and reducing the reliance on external demand and mitigate geopolitical risks.”

According to Chinese authorities, the average Chinese citizen has faced three main challenges over the past few decades: access to quality education, medical care, and housing. Although these issues have improved to different extents, the Common Prosperity Push aims to further resolve them by improving equality and social well-being. China is looking to reduce the income and wealth inequality that has grown over the past few years as well as reduce stress levels across its population. At the same time, it is looking to improve its educational systems and equalise educational opportunities between the rich and the poor.

While the intent to resolve these issues has been around for almost two decades, the number and velocity of regulatory policy changes has ramped up this year.

Evolution of corporate and regulatory policies

The regulatory policy changes are spread across a couple of main themes:

  • Data, privacy, & personally identifiable information. Data security, privacy, and, more specifically, national security are high on the regulators’ agenda. The government intends to stamp out the misuse of personal information. As such, we expect to see a heightened level of scrutiny of security and data sharing across Chinese Internet firms, especially those firms that have gathered a significant amount of personal data. Going forward, Chinese companies will be more limited in the use of personal information that they are able to gather and will have greater limitations on selling this data to others. This will reduce the amount that companies will be able to monetise data as compared with before these regulations. In addition, they will likely incur higher compliance costs, which could put additional pressure on future profitability.
  • Regulations on monopolistic and anticompetitive behaviour. Authorities are identifying the sectors in which the largest companies have a high concentration of revenue in that industry and, even more important, on those companies that authorities think conduct anticompetitive practices. We expect that those companies will be precluded from making additional acquisitions and will be pressured to either divest subsidiaries or will need to contribute to society in some way, such as funding charitable foundations or sharing a greater amount of their earnings with the government.

How evolving policies impact the valuations of Chinese stocks

There have already been numerous instances in which these policy changes have drastically impacted the valuations of the companies involved.

For example, earlier this year, DiDi Global’s DIDI stock was hammered almost immediately following its IPO as Chinese regulators instituted new data privacy and sharing requirements. In this case, China halted the ability to download DiDi’s apps across several app stores and ceased new user registration until Chinese authorities can audit DiDi’s data security and protocols. DiDi’s stock has since fallen 40% from its highs after the IPO.

In the education sector, Chinese officials have instituted regulations that will require companies that provide tutoring services to transform into nonprofit organisations and curtail the times and amount of tutoring that is allowable for students. Stock prices for New Oriental Education EDU and TAL Education Group TAL have been on a sharp downward slope since their February highs and have fallen over 90%.

Most recently, new limits have been announced on the amount of time that children in China will be allowed to conduct online gaming. Gaming will be limited to three hours per week and only allowed during specified days and times. However, considering how much the stocks of the impacted firms have already fallen from their highs, following the news, the stock prices of several gaming stocks were either stable or rose slightly. For example, both NetEase NTES and Tencent TCEHY had already fallen almost 40% from their February highs.

Not only have new regulatory policies impacted individual sectors and businesses but raising new equity capital will also become more restrictive moving forward. Chinese authorities are looking to control the amount of capital that is raised in the United States from new equity issuance and would prefer to see the equity issuance either brought back to the Chinese mainland or to Hong Kong markets. The focus here is on those structured vehicles used to issue shares in the US and on requiring firms to seek approval before listing overseas.

Further clouding the skies for Chinese ADRs, or American depository receipts, the US SEC won’t be standing still either. The SEC announced that Chinese companies seeking to conduct their initial public offerings in the U.S. will need to provide greater disclosure regarding their legal structures and the risks of additional political or regulatory actions to their businesses. In addition, the SEC is planning to step up its oversight of companies with a significant amount of operations in China. Finally, many institutional investors are advocating that Chinese companies should be held to the same level of audit scrutiny as US companies.

What does Morningstar see for Chinese stocks?

Considering the series of recent regulatory actions from the Chinese government, we don’t think that regulatory risks for Chinese companies are over. However, after examining the companies under our coverage on a case-by-case basis, we have maintained our fair value estimates, as we do not think further regulatory changes will have a meaningful impact on the long-term intrinsic valuations of these specific companies.

For the most part, we do not think that the companies we cover operate in those segments that will face the most onerous additional policy changes. And for those that do, we expect that the impact will be limited.

As an example, in our opinion, Tencent is a safer play among China Internet firms because of its known restraint in monetisation of data, more proactive social response initiatives, more compliant culture, and strong fundamentals. Even if the restrictions on gaming were more severe, the impact to our fair value for Tencent would only be 5%. We estimate that spending by minors represents only about 6% of Tencent's revenue and that spending by minors is only in the mid-single-digit range at NetEase.

Opportunities for investors

There’s still uncertainty as to the amount, timing, and substance of further policy actions. But we think that, following the downdraft in prices, the margin of safety provided among many Chinese ADRs adequately compensates investors for the added risks.

While Chinese ADRs have been the most adversely affected by the changes in regulatory policies, there are also a handful of US stocks that have been caught in the downdraft.

For example, the stock prices for Las Vegas Sands LVS and Wynn Resorts WYNN peaked in March and have been on a downward trend since then. Both companies generate a significant amount of their revenue from their casinos located in Macau. Currently, travel restrictions between the mainland and Macau have not been relaxed as expected because of the delta variant spread of COVID-19. Before the pandemic, Las Vegas Sands generated over half of its revenue from Macau, and Wynn Resorts derived about 80% from Macau. We currently rate Las Vegas Sand with a Morningstar Rating of 4 stars and Wynn Resorts with 3 stars.

Chinese stocks’ margin of safety provides cushion against additional policy actions

International investing carries additional risks, especially when it comes to evaluating the potential impacts that changes in foreign regulatory policies can have on industries and companies.

In this case, based on the wholesale sell-off across the Chinese stock market, it appears that some investors have decided to sell first and ask questions later. According to our analysis, for several Chinese stocks, the prices have dropped more than enough to provide sufficient margin of safety to cushion against additional policy actions. In our view, we think these stocks are significantly undervalued as compared with their long-term, fundamental potential.