Since our quarterly investment commentary was published in mid-July, new activity has taken place in China. In recent days, the Chinese government mandated that after-school tutoring companies, such as TAL Education Group and New Oriental Education & Tech Group, would need to be registered as non-profits and therefore cannot seek equity financing. Furthermore, foreign ownership would be banned in these companies. In essence, this is an example of China expropriating these private companies, and it inflicted huge losses on investors. This action raises questions for investors about whether investments in China are safe, if other areas are at risk, and what impact regulations will have on the profitability of private companies in the long run.
We have on balance been constructive on most of China’s recent regulatory actions, arguing these will ultimately lower risk and/or lay the foundations of sustainable growth. However, we do believe that China’s recent actions with respect to the private-education sector are concerning. China surprised many investors by taking such an extreme step, literally destroying a sector and its investors overnight. It is estimated to be a $100 billion sector; although relatively small, it is not a negligible sector of the economy. Investors now question what sector or industry could be next and how far China is willing to go if it finds an area of the economy not meeting its societal goals? How does China find the right balance, so it also meets its equally important longer-term goals related to innovation and balanced growth—both of which are also needed to stay in power?
At the moment, it appears that many investors are selling until they have clarity. The risk premium for investing in China has risen—it’s an unknown at this point whether this will be a permanent condition. Our thinking at present is to stay the course as we wait for more clarity. Our tactical overweight to emerging-market (EM) stocks is under review, as we have a lot of questions to assess. With that said, we do believe our assumptions are sufficiently conservative, and with recent price declines EM stocks have arguably become more attractively priced. We are actively evaluating this though, and our view may change based on more facts and analysis.
Having said the above, and acknowledging this is a negative event and at a minimum tempers the positive scenarios we had covered in our quarterly commentary, there are reasons, economically speaking, to think China’s actions on the education sector may not be the norm or at least not reflective of something broad-based across its economy. In our review of the possibilities, rather than the political view or just an acceptance that everything China intends will go as planned, we recognize there are many variables, some of which are unknown. It could be argued that China is looking longer term and has identified education as critical to sustainable growth and to managing inequality (which is already a problem). They started first by banning tutoring over the holidays and weekends, but that does not solve the problem because every Chinese student has to take a career-defining exam—gaokao. With only a small fraction gaining acceptance to prestigious universities, parents will do what they can to give their child an edge. But only affluent families could afford this tutoring, widening the education gap and in turn inequality, which China wants to address now before it becomes a bigger problem. And because tutoring is expensive, it becomes a disincentive for families to have more children, which defeats China’s goal of slowing or reversing its aging demographics. An aging society works against China’s longer-term goal of having a balanced growth model that’s driven also by domestic consumption not just fixed investment and exports.
We will continue to watch closely and look to see whether China rolls out broader education reforms. If they do, it could be a potential positive overall.
—Litman Gregory Research Team
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