Baillie Gifford China Growth discusses ‘biggest regulatory reset in a decade’ in dismal year – Baillie Gifford China Growth (BGCG) has posted its preliminary results for the year to 31 January 2022. During the period, the trust’s NAV total return was -27.0% and the share price total return was -37.1%, compared with a total return of -20.5% for the MSCI China All Shares Index* (in sterling terms).
BGCG saw weak share price performance from a number of its healthcare holdings as the sector sold off markedly in response to the likelihood of increased regulatory scrutiny.
The company has bought a number of stocks over the year that it believes are well positioned to benefit from China’s green revolution. These include Yunnan Energy New Material, a separator maker for large form batteries, Sungrow, an inverter maker for solar and wind farms, and Zijin Mining, a copper producer and enabler of China’s green infrastructure.
Returns are now generated from capital growth as opposed to income and the historic level of dividend is not sustainable. The revenue return per share was 0.97p, a decrease from 4.48p per share in the prior year, though most of that year’s income was earned under the previous investment objective. However, in recognition of the company’s sizeable revenue reserves, the board has agreed to pay out a dividend of 7.15p for the year to 31 January 2022 in line with the dividend paid for the last financial year.
Subject to shareholder approval, the final dividend of 4.60p will be paid on 27 July 2022, with the shares trading ex-dividend on 23 June 2022.
Investment manager’s report:
This year we have experienced one of the biggest regulatory resets in China for over a decade. Combined with a sell-off in growth equities towards the latter part of the year, it has been a painful period of performance for growth investors in China. At times like these, we believe it is important to stick unwaveringly to our long-term growth philosophy and process, both of which have served us well in the sixteen years that we have invested directly in China.
At the macro level, we continue to draw on our network of corporate, academic and independent research providers to help us navigate regulatory and policy change. As noted in our Interim Report, we believe there are two main policy drivers that require continued monitoring. The first is common prosperity and the second is anti-monopoly/data regulation.
With regard to common prosperity, we continue to believe that success here should be a significant positive for many of the companies in your portfolio and for China as a whole. So, what is common prosperity and why is it important? There are two facets to the policy: material prosperity and spiritual prosperity. Material prosperity is the most pertinent and can be summarised as ‘making the cake larger and cutting the cake better’. China’s economic miracle has already pulled c.800m people out of poverty. But it has also created vast inequalities of income, education, healthcare and opportunity, and this inequality is largely felt along rural/urban and provincial lines. As Li Keqiang noted in a recent speech, there are c.600m Chinese people living on less than RMB 1,000 (US$160) per month (or US$5.3 a day), barely enough to rent a room in one of the big cities. Indeed, China has one of the highest Gini-coefficients (which measures income inequality) in the world (at 0.48). As Scott Rozelle notes in Invisible China, educational outcomes are even starker: 75% of urban children go to university versus 15% of rural children, and 2/3 of China’s children are rural. With China losing its low skilled manufacturing jobs to Bangladesh and Vietnam, it risks being left with a large underclass of under or unemployed citizens who are unable to contribute meaningfully to consumption led economic growth. Common prosperity is the government’s attempts to tackle these issues so it can meet its development goal of attaining developed market status by 2049, the 100th anniversary of the PRC.
But what about ‘cutting the cake better’? Does this suggest a return to a markedly less palatable form of communism? We do not think so. Xi’s view of wealth distribution is olive shaped (a large middle class and smaller groups of very rich and very poor people). With the wealthiest three provinces in China generating 4x the GDP per capita of its poorest (the ratio in the US is only 2:1), a certain degree of redistribution will be required. However, as Dr Olivia Cheung from SOAS notes, Xi has explicitly ruled out the creation of a welfare state arguing that it ‘breeds laziness’ and, importantly, still promotes the idea that it is ‘glorious’ to become rich, as long as the rich give back to society.
So what key milestones will we be monitoring with respect to common prosperity? Zhejiang Province is the pilot province for the policy and a likely early indicator of the direction of travel at a national level. More broadly, an increase in wealth transfers from richer to poorer areas, an improvement in rural land rights, and further relaxation of rural hukou (essentially, residency permits) would be viewed by us as meaningful and positive developments.
With regard to anti-monopoly and data regulation, there are a number of things to note. First, regulating large technology conglomerates and their use of data is a global, not a local, issue. Governments all over the world are struggling to formulate best practice here and China is no different. Second, the issue in China is heightened by the remarkably lax regulatory environment prior to 2021; and by the government’s desire to incentivise investment in areas that will be crucial to China’s next decade of economic development; it doesn’t want all of its best and brightest minds to become game developers and ad optimisation programmers! Third, whilst the broad parameters of anti-monopoly and data security regulations have been set, we are still waiting for detailed guidelines and implementation from a host of newly created and recently empowered regulatory bodies. For example, the State Council recently added ‘data’ as a 5th factor of production and, in concert with the cyber security regulator, is trying to formulate mechanisms via which certain types of data are safe to trade. SAMR, the body in charge of anti-monopoly regulation, is currently in the process of revamping the Anti-Monopoly Law and in defining new types of anti-competitive behaviour. What this means in practice, is yet to be announced.
All of the above affects two of our largest holdings, Alibaba and Tencent. These are two of the most dynamic companies within China. They have multiple potential growth drivers ahead of them and, as such, sit at the nexus of multiple regulatory jurisdictions. Until we get clearer guidance from regulators on what both companies can and cannot do in the future, we think it is unwise to make very large changes to both stocks’ position sizes, particularly after a period of such marked weakness in both companies’ share prices. For example, both companies have until now been able to expand horizontally into new growth areas unimpeded. Will this be allowed to continue? One of the attractions of both companies was their vast stores of consumer and financial data. Will they still be able to monetize this given the proposed restrictions to the use of personal data or will both companies be massive beneficiaries of the government’s decision to add data as a 5th factor of production? Finally, although both companies remain large absolute holdings, their relative weights are much smaller. This reflects our uncertainty regarding the impact of the new regulatory regime on both companies’ future growth prospects.
More positively, outwith the internet space the government continues to show support for sectors which will be key for China’s next decade of growth. As the Industry and Information Technology Minister Xiao Yaqing highlighted in a recent essay, China wants to avoid the hollowing out of its manufacturing sector and to increase self-sufficiency in areas outwith the digital economy. These areas include advanced manufacturing, environmental technology and semiconductors. It wants to nurture an array of ‘little giants’ that have the potential to develop highly advanced expertise in these strategic areas. We believe these ‘little giants’ reflect very sizeable growth opportunities for long term investors.
BGCG : Baillie Gifford China Growth discusses ‘biggest regulatory reset in a decade’ in dismal year