Chinese tech companies have sold off heavily in recent months. Investors have been dumping shares as the government has clamped down on companies that it believes are falling foul of regulations. And it would appear that this is not going to end anytime soon.
The Chinese government has now unveiled a five-year plan outlining tighter regulation for much of the economy, including the technology industry.
Regulations for the digital economy, including internet finance, artificial intelligence, big data, and cloud computing, will be reviewed. So will rules relating to monopolies and laws in certain fields such as science, technological innovation, culture, and education, which the government believes are important sectors for national security.
This suggests the outlook for companies like Alibaba Group (BABA, Financial) and Tencent (TCEHY, Financial) is highly uncertain. These are not the only ones. Firms like NIO (NIO, Financial) and DiDi (DIDI, Financial), as well as Pinduoduo Inc (PDD, Financial) and JD.com (JD, Financial), may see their market power curtailed or have to comply with additional regulations in the future.
This presents a dilemma for investors. On the one hand, China is the world's second-largest economy, and over the past few decades, it has achieved the fastest transformation in history from an underdeveloped third world country to one of the world's top economic and political powers.
Economic powerhouse
The country benefits from a combination of factors that have helped it during this time. Economic reforms and policymakers' ambitious five-year plans have transformed the economy, inspired innovation, and lifted hundreds of millions out of poverty.
At the same time, the country's education sector has blossomed, and students, powered by a mentality inspired by hard work, have gone on to drive the economic revolution, drive innovation and further push the economy forward.
Past performance should never be used as a guarantee for future potential, but many of the factors that have helped China grow over the past two decades are still present.
This implies that the region's growth is not going to stop. What's more, compared to Western nations, some sections of the economy are still underdeveloped, leaving room for growth in key sectors such as finance.
If growth in these sectors, and the broader economy, in general, is anything like it has been over the past decade, investors cannot afford to avoid China. But is it possible to invest in a region where sudden changes in the law can wipe out a company's equity overnight?
Overnight wipeout
Chinese education stocks have seen their market value fall more than $100 billion since the beginning of this year after policymakers decided to clamp down on the sector.
Shares in Tal Education (TAL, Financial) have fallen nearly 90% since the middle of February.
This is the dilemma investors face. In the long run, all of these companies may be able to ride the rising tide of the Chinese economy. However, they could be shut down along the way.
At the 2007 meeting of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholders, Warren Buffett (Trades, Portfolio) laid out his approach to value stocks. The relatively simple discounted cash flow analysis can be a good indicator of company value, but it is impossible without having a high level of visibility over cash flows. As Buffett said:
"There are all kinds of businesses that Charlie and I don’t think we have the faintest idea what that future stream will look like. And if we don’t have the faintest idea what the future stream is going to look like, we don’t have the faintest idea what it’s worth."
If one cannot say with any certainty if the cash will be there five years from now, it is impossible to value the business. This suggests that despite the tailwinds the Chinese economy is providing, many Chinese equities are now uninvestable.
