Rethinking the Underlying Models of Chinese and Western Approaches to Investment
Recently, the news that the education industry in China has cooled down has been trending and has caused a lot of shock. This is an issue that affects a wide range of people and businesses (over 200,000 institutions, 8 million employees, and tens of millions of students, with a market worth over trillions of RMB), and it was almost completely wiped out overnight. Although there were many signs pointing to this event, many investors did not include education and training in their investment portfolios, but the impact is still significant. For foreign investors who came all the way to invest in China, this news is difficult to accept. Therefore, there is a systemic concern about extending this event to Chinese stocks and the overall Chinese asset market, such as delisting, the sustainability of VIE structures, and concerns about the one-size-fits-all regulatory approach in other fields.
Therefore, from this perspective, we need to understand the Chinese model more deeply and understand the importance of the opportunities and risks of investing in China for long-term investments through this event.
Regarding the Chinese model, whether it is the Sino-US trade, political disputes, Hong Kong events, or the recent governance of real estate, education, medical, e-cigarettes, and Internet anti-monopoly regulations, there are deep logical chains, which can be traced back to Eastern and Western cultures, and the mainland and maritime systems. There are too many details and many articles have discussed them, so I will not delve into them too much here.
Simply put, one of the major differences between the Chinese and Western models comes from the strong centralization of Chinese thinking. This may stem from the patriarchal thinking that arose from the agricultural civilization and the centralization of thought caused by mainland culture, which fundamentally differs from the individualistic thinking that emerged from the maritime civilization. Although the two civilizations have merged after thousands of years of development and conflict, the differences between them are still apparent today.
In a patriarchal system, the head of the family is the absolute authority, and rules and institutions are mostly tools. However, in the commercial civilization of the maritime civilization, rules and institutions are strongly binding, and no one can be above them, unless they are changed through collective will. This is also why many Westerners do not understand the Chinese model, as well as the Sino-US trade conflicts, conflicts over Taiwan, Hong Kong, and the South China Sea, as well as the reasons for the introduction and adjustment of various industrial policies in China. The current core of the Chinese model is not to follow the West or certain interest groups, or even to follow too many rules and principles, but to adapt and change according to the "core interests" of the Chinese nation, which is a characteristic of the socialist system with Chinese characteristics. Based on this "core interest," we can either fight bravely or reconcile with foreign countries, and we can actively encourage internal policies when needed, or set them as enemies to suppress when they violate our future goals.
Just as "socialism" revolves around "society" or "public interest," and "capitalism" revolves around "capital," the governance models and legal frameworks that emerge from them are very different. Investors cannot expect investment models in China to be the same as those in the West, as this adds a lot of difficulty, requiring a deep understanding of political intent in addition to rules and systems.
Opportunities and Challenges of Investment
We know that a significant part of investment valuation is based on the evaluation of future and long-term values, rather than judgments on the next one or two years. In a more stable system with rules and frameworks, investors will feel more confident in making long-term judgments (of course, it cannot be completely accurate). In this system, investment is more about conducting competitive analysis in a relatively more certain market and selecting winners. In contrast, in a system where political intent needs to be constantly speculated, and this intent may significantly lengthen or reduce the judgment of future cash flows, investors have to consider the government's guidance more in investment to avoid extreme problems such as "the moat is still there, but the city is gone."
The reason why "letting go leads to chaos, and tight control leads to death" often stems from the fact that rules and frameworks cannot be stable in the long term and ultimately have to be subject to political intent. However, whether it is investment or career choices (career choices are essentially a kind of personal belief investment), one has to make long-term fundamental judgments and short-term adaptive choices following the government's guidance. Therefore, in investing in China, "following the Party's lead" is necessary.
As a result, there is a judgment on the final valuation of China and the United States.
Even many professional strategy analysts and investors often mention that the market value of Chinese companies as a percentage of GDP is significantly lower than that of other countries, especially lower than that of the United States, so they are optimistic about the Chinese market. We agree with the conclusion that there will be many companies with great investment potential in China in the future, but the logic of this argument is full of fallacies, and it oversimplifies the comparison of the market conditions between China and the United States (perhaps to prove its beautification argument). As described earlier, the differences between Chinese and Western systems are huge.
Furthermore, investing in American companies is essentially borrowing Uncle Sam's power (including financial, cultural, political, and military influence) to invest in companies that can dominate the world in the future. This ability cannot be simply compared with American domestic GDP. Moreover, the underlying motives of the American small government mechanism and using corporate entities to expand global commercial interests will unconsciously help business interests continue to grow. Therefore, investing in American companies is actually supported by the US government's implicit support, and it is an investment opportunity for global market companies. And due to the institutional arrangements in the United States, there is probably little need or very little consideration of conflicts of interest between private and public sectors. Historically, the image of the American small government rarely needs to consider the situation where business institutions influence their authority.
The opportunities and risks of investing in China are as follows:
Opportunities:
A vast and rapidly growing market (supported by a large and growing middle class).
Risks:
Conflicts between private sector interests and public sector interests may lead to policy changes that affect industry demand and competition. For example, competition in the private sector may become more intense, or companies may need to assume more social responsibility.
To mitigate potential future risks, excessive reserves must be set aside, reducing potential cash flows and lowering ROE for investors.
The Confucian culture of filial piety rather than contractual obligations may lead to discounted returns for investors due to conflicts between entrepreneurs and investors.
A Few Words on the Education Sector
Despite its harshness, the policy intention is justifiable
We've all seen a lot of discussions about education, and we can understand the policy intention. For the vast majority of students, excessive K12 (and even pre-university) subject-based test practice is a form of "involution" that consumes a lot of social resources, but does not have any clear long-term benefits. Therefore, from the perspective of policy objectives, the only viable paths are to either support comprehensive education or completely negate it. Partial restrictions would only exacerbate social grievances and inequality.
On the other hand, with the decline in birth rates, K12 education resources are already abundant. After eliminating shadow education (tutoring), returning education to schools and restoring its compulsory nature is the government's social responsibility, even though the means may seem too cruel to the industry's practitioners. However, the Chinese model has always been ruthless in suppressing any "selfish" interests that may affect the overall situation, even to the extent of sweeping away entire industries, as seen in the recent crackdowns on internet finance and cryptocurrency.
But the concern for higher and vocational education may be excessive
We can understand investors' fears of the education sector, as it still involves livelihoods, and while it is currently encouraged and supported, the possibility of sudden setbacks cannot be ruled out.
However, we still believe that such concerns may be excessive given the current valuation:
In the medium term, policies can maintain continuity: The attitude of the People's Mediation Law towards higher and vocational education is almost entirely supportive, which is a refreshing breeze in the entire education sector. Although it's hard to determine its effectiveness period, considering that the big direction is set, there won't be significant changes in the next 5-10 years at least (otherwise, how could the policy attract social participation?)
Fits the era's development and policy objectives: From the perspective of policy objectives, the overall supply of compulsory education is greater than demand. However, higher education and vocational education still have room for growth, given the current gross enrollment rate of only 50%, and there is still a significant unmet demand. Therefore, the demand for private education remains.
From the perspective of diversified supply and the strength of public institutions, subject-based education in K12 is quite standardized. While public institutions may provide slightly inferior services compared to private ones, they are essentially homogeneous. Higher education and vocational education cater to a more diverse range of social needs, requiring continuous updating, and private institutions can supplement what public ones cannot offer (though only to a limited extent, as the current 20% ratio is unlikely to significantly surpass the status of public institutions).
The social responsibility of higher education is smaller than that of compulsory education: After all, the targets of higher education and vocational education are generally over 18 years old and have already reached adulthood, can immediately enter society and gain returns after graduation, and have more autonomy. Therefore, in terms of society's requirements for fairness and efficiency, there is more need for efficiency, while K12 education is predominantly oriented towards fairness.
Not excessively market-oriented under strict supervision: From a historical perspective, educational qualifications have always been subject to strict supervision. Even in recent years, many places have gradually opened up the reporting and pricing of educational qualifications (which is still regulated). Therefore, the tuition fees of private higher education institutions nationwide are only around 10,000 to 15,000 yuan (approximately $1,500 to $2,200), regardless of whether they are relative to national household income (which is $14,000 multiplied by 2) or potential future income in the five years after graduation, which is assumed to be slightly higher than the national per capita income of $10,
From the perspective of valuation and pricing, it may be undervalued: Due to concerns about policies and discounts on liquidity of relatively small market capitalization, the valuations of China's higher education and vocational education sectors are generally in the range of 10-20 times earnings. However, for companies with stable cash flows and potential for 15-20% growth over the next 3-5 years, and the ability to achieve 20-30% compounded growth through reasonable capital allocation, with a dividend payout rate generally between 40-50%, the expectations may be too low.
Just like there is no risk-free investment or one-size-fits-all strategy, while it is difficult to say that the market's concerns are entirely unfounded, for example, the possibility of the government cracking down on higher education and vocational education again in 5-10 years, or potential risks in policy implementation, just like there is no perfect person or company, under the current industry and policy analysis, as well as the probability basis of current pricing, we still believe that investment in the education sector is not without merit.
The Strategy Choice in Current Market Environment
Investment is always a judgment about the future, even for so-called "value investing". Unless the value is undervalued to an extremely low level, such as through liquidation, and cash returns can achieve value regression in a short enough time, investment still involves many judgments about the future. However, investors believe that this expectation is conservative enough. In this sense, the difference between "value" and "growth" is more about the difference between investors' conservative or aggressive attitudes towards the future. Therefore, even extreme "speculative" behavior can be correct sometimes, but the probability is not high enough. Therefore, to further explain, apart from the simplifying terms such as "investment", "speculation", "value", and "growth", investment is essentially based on the probability and success rate judgment of the future.
Besides "listening to the party," we also need to make judgments based on current odds and success rates.
Although we mentioned earlier that we must "listen to the party" in investing in China, is it brainless to rush into anything supported by the government, regardless of the competitive environment and prices? This is obviously too short-sighted and contrary to our value-based investment approach.
We believe that the current market expectations have already reflected the direction of policies to a more extreme degree, and of course, we can choose to:
Further magnify policy concerns and abandon the suppressed Internet, education, and even the pan-service industry;
Fully engage in the manufacturing industry and embrace new energy vehicles, photovoltaics, and other popular industries;
Completely shift to the US stock market and embrace American assets. We believe that chasing the investment model of newspaper headlines is not the same system as our value investment approach that pursues the long-term probability and success rate. We believe that there are institutions that are naturally better at this investment model. This is not our value and methodology.
We do not misunderstand the change in market direction, but we prefer to put these expectations into our model framework for judgment to determine whether current prices have sufficient returns;
We do not look down on the manufacturing industry, and we have always held shares of China's semiconductor leader TSMC. However, we are not willing to blindly buy some competitive products that have not been established or have overly high expectations at 100 times or even higher prices;
From the current expectations and expected returns, the suppressed Hong Kong stock service industry and some Chinese concept stocks may provide higher returns than US stocks.
Finally, our investment methodology is to quantify various expectations as compound interest and expected probabilities, and then make our final decisions on choice and position. The current market expectations for popular industries may still be too high, and some companies that have been suppressed more by emotions may eventually return to value over a longer time period if they have solid fundamentals.
The table below is for reference only, and this forecast represents only personal views. The stocks listed in the table do not represent holdings or recommendations：
Of course, there may be a need for moderate balance in long-term strategy.
Based on the aforementioned, from the perspective of long-term asset allocation, if one still hopes to make long-term investments in growth opportunities in the future, it may also require:
Moderate diversification of Chinese assets, as the unpredictability of the Chinese model comes from the industry and policies.
Balanced investment in Chinese and US assets to moderate risk diversification.
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