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Can Chinese Stocks Rebound In 2022?

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By Hugo Pan

2021 was a monumental year for Chinese stocks trading in the U.S., in ways both good and bad. On the one hand, Chinese companies set a record for number of IPOs in the U.S. On the other hand, challenges in those IPO processes and regulatory conditions led to a large sell-off in China and Hong Kong indices and to some of these stocks setting multi-year lows. As we enter 2022, is there a reason to expect a change?

Chinese Stocks Transformed from Gimmicks to Value Investments

The so-called “China Concept Stocks” is a collective term for all Chinese stocks listed overseas.

In the 1990s, Chinese companies began to experiment listing in the United States. Shanghai Petrochemical (NYSE:SHI) (Sinopec) became the first Chinese state-owned enterprise to be officially listed and traded on the NYSE as a pilot company, in July 1993.

Over the last 20 years of China’s economic growth, the “China concept” has changed from a gimmick to a profitable investment. Many Chinese companies have gone public in the U.S. and risen significantly in valuation. Alibaba (NYSE:BABA), currently the largest Chinese company on the U.S. stock market, was valued at $21.8 billion when it went public in 2014, and at one point reached a value of more than $860 billion, or 40 times growth.

The presence of Chinese stocks in the U.S. has expanded rapidly over the past 15 years. In 2005, only 36 Chinese companies were listed in the U.S., with a total market value of about $260 billion between them, accounting for just 1% of the total market value of U.S. stocks. By the end of 2020, there were more than 600 Chinese companies listed in the U.S., with a market capitalization of about $6 trillion, accounting for nearly 9% of the total.

In 2021, with the tailwind of promising data from the pandemic recovery, as well as U.S. market buoyancy, the number of Chinese companies IPOing in the U.S. exploded. Refinitiv data reported 34 U.S. IPOs by Chinese companies in the first half of the year alone, well above previous records.

Chinese Companies Become Chinese Beggars

But as 2021 wore on, the market climate suddenly changed. The NASDAQ Golden Dragon China index reached a record high of 20,893.02 in February, and reached as low as 8,275 (as of December 20th), a drop of 60%. Alibaba fell 58% from highs, Didi (NYSE:DIDI) fell 64%, Pinduoduo (NASDAQ:PDD) fell 73%, and these are just examples. Many Chinese stocks fell by more than 90%. No one expected that the thriving Chinese stocks would so quickly flip from desired goods to unholdable assets that had to go on fire sale prices, costing investors a great deal of money.

What Brought Us to This Point

There was a series of events that led to 2021’s tumultuous trading.

In March 2019, the U.S. proposed the Holding Foreign Companies Accountable Act (HFCAA), which set a high bar for Chinese stocks listed in the U.S. The law requires companies to provide audit primers to the U.S. Public Company Accounting Oversight Board (PCAOB) within three years of listing or face risk of delisting.

On April 2, 2020, Luckin Coffee issued an announcement admitting to false transactions of RMB 2.2 billion and its share price plummeted 80%. In May 2020, the U.S. Senate unanimously passed the Holding Foreign Companies Accountable Act after Ruixing’s (Luckin) financial fraud case. The law would be signed into effect by the end of 2020.

On July 1, 2021, Didi Global quietly went public in the U.S. without ringing the bell or any publicity. The stealth list of a $400 billion market cap giant alarmed the market, so that the Nasdaq Golden Dragon China Index plunged 2.5% that day.

On July 2, 2021, the Chinese Cybersecurity Review Office announced the launch of a Cybersecurity Review of Didi Chuxing, and the Golden Dragon China Index fell another 1.9%.

On July 6, 2021, China issued “Opinions on Strictly Cracking Down on Illegal Securities Activities in accordance with the Law”, which mentioned strengthening cross-border regulatory cooperation and requiring the implementation of the main responsibility for information security of overseas listed companies. The Golden Dragon China Index fell another 3%, down 12.7% from July 1.

On July 24, 2021, the General Office of the CPC Central Committee and the General Office of the State Council issued “Opinions on Further Reducing the Burden of Students’ Homework and Off-campus Training in Compulsory Education”, and education stocks took their turn to plunge. That day, New Oriental (NYSE:EDU) fell 54.2%, TAL Education (NYSE:TAL) fell 70.8%, and Gaotu Techedu (NYSE:GOTU) fell 63.3%. This dragged the Golden Dragon China Index with it, as the index plunged for three consecutive days, down 16%, with a cumulative drop of 22% for July.

In September 2021, China Evergrande Group (HK:3333) was exposed to have RMB 2 trillion of debt, and rumours of bankruptcy began to fester. Evergrande’s share price also began to plummet, falling over 60% from that point after already dropping 75% going into September. Foreign media even compared it to the “Lehman” moment, which exacerbated the sell-off in Chinese stocks. The Golden Dragon China Index fell by almost 10% in the month.

On December 2, 2021, the SEC adopted the final rules of the Holding Foreign Companies Accountable Act. The implementation means as of 2022, if the PCAOB fails to review the issuer’s accounting firm for three consecutive years, the stock will be banned from trading on the national exchange and will be mandatorily delisted from the U.S. stock market (i.e., in 2025). Following the news, the Golden Dragon China Index fell 2.1%.

On December 3, Didi Chuxing announced in a microblog, “the company will start the work of delisting from NYSE and start the preparation for listing in Hong Kong with immediate effect”. Although the company has yet to make a formal announcement, Didi’s declaration reflects additional net security regulations. The Golden Dragon China Index plunged more than 9%, again.

One negative after another smashed Chinese stocks and dumbfounded investors throughout 2021. This rolling sell-off contrasted sharply with the Nasdaq Composite Index, which was up 16.2% year to date as of December 20th. The difference was day and night.

Looking Ahead to 2022 – Chinese Stocks Outlook

So where do Chinese stocks go from here? Here are three possible scenarios.

1. Going Public in Hong Kong

Companies must always be prepared for the worst, which in this case means considering a Hong Kong listing. Although the U.S. Holding Foreign Companies Accountable Act still has a three-year window (ending in 2025), if the market is still tight next year, we can’t rule out the possibility of a large number of Chinese stocks going to Hong Kong for a second listing.

CITIC Securities believes that the tightening of overseas regulations, coupled with the gradual liberalization of Hong Kong stock market listing rules and index inclusion, will accelerate the return of Chinese leaders eligible for listing on the Hong Kong stock market. The secondary listing in Hong Kong only needs to meet the regulatory requirements of both markets, and the return of eligible Chinese stocks to Hong Kong for secondary listing will become mainstream.

For companies that do not meet the requirements for secondary listing in Hong Kong, the likely alternative is the risk of privatization and delisting before 2025. Due to the large scale of capital consumed to buy out public shareholders, high compliance costs, and the difficulty of dismantling public shareholder structures, this is less likely to be a popular choice.

In fact, many foresighted Chinese stocks have already planned the back way early. In 2021 alone, star Chinese stocks such as Baidu (NASDAQ:BIDU), Bilibili (NASDAQ:BILI), Trip.com (NASDAQ:TCOM), Weibo (NASDAQ:WB), Li Auto (NASDAQ:LI), Xpeng (NYSE:XPEV), and Autohome (NYSE:ATHM) have gone to Hong Kong for secondary listings.

There are diverse opinions on the impact of this inflow of companies to Hong Kong. Some believe this will put pressure on the liquidity of the Hong Kong capital market, being far smaller than that of the United States. As of December, the total market capitalization of Chinese stocks is about US$1 trillion, and there are 31 ADRs of large blue chips in the Hong Kong market traded in the U.S., including Tencent (OTC:TCEHY), financial real estate stocks, and Hong Kong-owned utility stocks. Their return will generate financing demand on a large scale, creating a strong bloodletting effect, straining the Hong Kong market. Hong Kong stocks already struggled in 2021 and will hardly be able to withstand another big tumble.

But the benefits of big names relisting in Hong Kong are also obvious. Hundreds of billions or even trillions of dollars will flow back to Hong Kong, which will inevitably strengthen Hong Kong’s position as Asia’s financial centre. Some people also believe that the best quality Chinese stocks are not afraid of turbulence, because whether they list a Hong Kong ADR or not does not affect their prospects.

2. Return to A-shares

With the launch of the Science and Technology Innovation Board and GEM registration system pilot, Chinese stocks can also choose the channel of direct stock issuance to list in domestic A-shares.

Yuekai Securities believes that due to the scarcity of hard technology targets in the A-share market, the returned Chinese stocks will obtain a higher valuation premium, which will drive up the market value and liquidity of the stocks. This could have a positive feedback loop as local investors bid up the newly (re)listed companies, which would be a key to promote the return of Chinese shares to A-shares in the future.

3. Value Returns

Under the influence of tightening regulation, increasing anti-monopoly investigation and increasing policy measures, Chinese stocks suffered through 2021.

Shanghai Securities believes that as it has been nearly a year since the first mention of anti-monopoly by the government, and that the policy’s starting point is to promote and benefit industry rather than wipe out leaders, the market will gradually rationalize and responses to regulatory policies will slow, leading to a bottom for the Internet industry, especially the Hong Kong Internet companies. There are parallels to regulation on U.S. internet leaders, where negative effects are often temporary and limited.

In the context of China’s economic transformation and strong science and technology, the long-term positive trend of the Internet industry remains unchanged. As regulation normalizes, the market may move its focus back to the companies’ performance and potential quality.

As seen from the above timeline, the whole macro environment is dragging down Chinese stocks as much as anything else, distracting from their still-strong outlooks. As the bear market has overshot, there are many Chinese companies whose stocks are trading below potential value.

For example, Alibaba’s shares have hit a nearly 5-year low and are close to breaking a $100/share price, leaving shares really tempting. With a P/E Ratio of 17, an EV/S ratio of 2.5, and a market cap of just over $300 Billion, the internet giant may be attractive.

There were safe havens in the Chinese market. For example, electric car maker XPeng Inc. only dropped 8% while Li Auto is down only 2%, as its stock hasn’t fallen with the rest of the sector.

Luckin Coffee (OTC:LKNCY) is another surprise story, gaining 17% in 2021 despite trading on the pink sheets, as investors have bought into its focus on optimizing cost control and focusing on the core business to shed the reputation of past fraud.

Then there is JD.com, which has fallen 17.32% in 2021, but has been in rebound mode from August to November before getting hit by year-end volatility.

This shows that there remains a bid for Chinese stocks and that investors’ confidence in the remaining Chinese stocks has not been completely lost.

In fact, global investors have already bought into what might be the bottom. Warren Buffett’s partner Charlie Munger, High Tide Capital, and Bridgewater Associates have increased their holdings of Alibaba; capital giants George Soros and Duan Yongping have increased their holdings of Pinduoduo, and Perseverance Asset Management and Greenwood Assets have increased their holdings of Kanzhun (NASDAQ:BZ) and KE Holdings (NYSE:BEKE).

ETF flows are also growing. Take the EFund China Overseas Net 50 Fund (SS:513050) as an example: it has received net subscriptions every month since 2021, allowing it to buy as prices fall, with a combined net subscription share of 20.998 billion shares as of December.

The ideal scenario would be for the U.S. and China to get back on track economically and in trade relations. That and the end of the pandemic could provide meaningful tailwinds for Chinese companies which are trading at depressed valuations. A rosier macro environment and Chinese stocks can sweep away the gloom of 2021 and shine in 2022. If that environment doesn’t emerge, investors may need to keep an eye on the Hong Kong and A-Share markets instead.

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