Chinese stocks collapse: buy the downside or stay away?

If you’ve been focusing on US stocks, you might not have noticed the huge Chinese tech stocks lately. Just look at the China Internet Focused Exchange Traded Fund KraneShares CSI China Internet ETF (NYSEMKT: KWEB), which is down 36.3% from its all-time highs in February.

KWEB data by YCharts.

To give you an idea of ​​the quantity of a drop, it is a little bigger fall that the S&P 500 saw in the February-March 2020 COVID-19 crash!

This may be very surprising to some, especially since we are currently in a global recovery from the COVID-19 pandemic. However, Chinese tech stocks, after surging earlier this year, are now squarely in the crosshairs of the Chinese Communist Party, which is cracking down hard on the country’s burgeoning tech sector.

High uncertainty and extreme fear seem to take hold of Chinese equity investors, who appear to be taking a “sell now, ask questions later” approach. Still, for those with a long-term focus, the current extreme pessimism could be a golden opportunity to initiate or increase exposure to the best Chinese tech stocks.

While I am leaning more towards this as a good opportunity, there are also some big risks you will need to consider when investing in China.

A man in a suit steps back in front of his tablet sitting outside.

Image source: Getty Images.

What is going on in Beijing?

Triggered by retaliation against Ali Baba (NYSE: BABA) Comments from founder Jack Ma last fall ahead of Ant Financial’s (now abandoned) initial public offering (IPO), Chinese regulators have launched a sweeping crackdown on Chinese tech companies, with countermeasures ranging from anti-monopoly sanctions to data privacy investigations to new rules regarding overseas listings. Here are some examples.

Alibaba not only had its Ant Financial IPO canceled by government authorities, but was also fined $ 2.8 billion for coercing brands into exclusive deals in exchange for access. to its main e-commerce platform. And in recent days, Chinese authorities have also brought down the hammer Didi Global (NYSE: DIDI) just days after its initial public offering in the United States, limiting new downloads of the app, essentially preventing the company from adding new users (although existing users can still continue to use the service). Ditto for other Chinese companies newly listed on the stock exchange Complete Truck Alliance, a digital trucking and freight platform, and Kanzhun Limited, an online platform that connects job seekers and employers. For what it’s worth, I highlighted these regulatory risks for Didi ahead of its listing last month.

The reasons for the crackdown given by Chinese authorities focus on data privacy, especially in light of the disclosures now required of Chinese companies listed in the United States. raise funds abroad through variable interest entities located in the Cayman Islands.

It is not clear whether this regulation would actually be adopted, and if it was, whether it would apply only to new registrations or also retroactively to companies that have already registered in the United States.

What investors should do: Weigh big opportunities and big risks in tandem

Given that China has four times the population of the United States, a growing middle class, and a highly advanced tech sector, it may seem like the current sale is a golden opportunity. After all, many top tech stocks are now cheaper than their US counterparts, despite having potentially larger addressable markets and growth prospects.

In addition, China has already experienced various “waves” of government regulation, such as the anti-corruption campaign launched ten years ago. Chinese stocks were also hit hard at the start of the trade war in 2018, but eventually hit new all-time highs. So there is a good chance that this sell-off in Chinese stocks, like others in recent years, will turn out to be a gold buying opportunity.

KWEB chart

KWEB data by YCharts.

On the other hand, for American investors, there are big risks. Some may own shares of Chinese companies listed in Hong Kong, but many US investors have variable interest entities (VIEs) registered in the Cayman Islands and directly listed on the US stock exchanges. Although a company may be listed in the United States, American investors do not actually own shares of the underlying company, but rather a VIE that is entitled to an economic interest in that company through a contractual agreement. These contracts seem pretty secure, but when the Communist Party gets involved, it may be enough to ban these VIE contracts and therefore force the sale of Chinese stocks listed in the United States.

Other investors can also own Chinese companies through American Depositary Receipts (ADRs), which essentially allow US investors to hold internationally listed shares of foreign companies owned by a US broker or bank. If the US-China tensions result in sanctions or bans on owning certain types of companies, these banks or brokers may end their ADR programs for fear of being subject to sanctions.

My own feeling is that things won’t go that far, especially for the big consumer-focused and international tech giants such as Alibaba or Tencent. After all, if China is to be a bigger player on the world stage, it won’t gain many fans by essentially stealing billions from foreign investors.

If you don’t own Chinese tech stocks, this might be a great time to grab some of the highest quality, best managed Chinese tech names on the cheap. After all, Warren Buffett’s partner Charlie Munger did it recently.

However, investors also cannot ignore the worst-case scenario of ADR cancellation or a problem with the VIE loophole. Therefore, investors should only invest the portion of their portfolios that is allocated to high risk stocks. This could be 1% or 2% of your holdings or up to 10% to 20% for young investors.

Either way, interested investors should keep their eyes peeled as these rapid developments unfold.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.