China Internet

KWEB China Internet Market Volatility FAQ

Below we have compiled the five most frequently asked questions on the recent market volatility:

  • What are some near term green shoots you are seeing following the recent regulatory uncertainty?
  • Is there a timeline for when the recent wave of new regulations will end?
  • Is China explicitly targeting US-listed Chinese internet companies with new regulations?
  • How might KWEB be affected by the U.S. delisting legislation? Can you convert US-listed shares to Hong Kong shares for companies with dual listings?
  • What do you think the parallels are between past regulations on internet companies versus now?

What are some near term green shoots you are seeing following the recent regulatory uncertainty?

We have received new details on several specific near-term dates for regulation to take effect. China’s Data Security Law, which will cover the usage, collection, and protection of user data, will go into effect starting September 11. The Personal Information Protection Law, which also protects internet user data, will go into effect on November 12. We believe clarity on timelines for these new regulations is positive for the market. We expect to hear additional dates announced soon.

On August 20th China’s top market regulator, China Securities Regulatory Commission (CSRC) issued a statement pledging to “create conditions for audit cooperation with the U.S.” Previously, Chinese regulators prohibited US-listed Chinese companies from providing their audit papers to the US Public Company Accounting Oversight Board (PCAOB). The CSRC’s announcement removes a major roadblock for Chinese companies to continue listing on US-exchanges.

Other green shoots include the strong earnings that have been reported from several Chinese Internet companies over the past few quarters and year. We have listed highlights from select companies most recent earnings reports:

  • Tencent revenues increased 20% to $21.4B quarter-over-quarter3.
  • Baidu revenues increased 20.4% to $31.35B year-over-year4.
  • JD.com revenues increased 26.2% to $39.9B quarter-over-quarter5.

We’ve also observed more stock buybacks by Chinese Internet companies, a sign that these companies believe their stocks are undervalued:

  • Tencent has bought 650k shares in the last three days as of August 23.
  • Baidu has bought $3B of shares since April 1 as of August 23.
  • Alibaba increased buyback program to $15B from $10B on August 3.

Lastly, the continued growth of online retail sales within China further demonstrates the rapid growth of the sector:

  • From January to July of this year, online retail sales reached 7.1 trillion yuan (1.01 trillion USD), a year-on-year increase of 21.9%6.

Is there a timeline for when the recent wave of new regulations will end?

As a general guide, we refer to The Ministry of Industry and Information Technology (MIIT), which announced that a six-month review of internet companies commenced on July 23. The review encompasses cybersecurity, data privacy, consumer protection, and monopolistic behavior. So far, 68 leading Internet companies including Baidu, Alibaba, Tencent, ByteDance, Sina Weibo, and iQiyi have completed rectification as required7.

Additionally, on July 6, China’s State Council released guidelines on curbing “illegal activities in the securities market and stepping up supervision of Chinese firms listed offshore8”. The document outlined a 2022 timeline for “major progress” to be made on these issues, which aligns with the timeline set forth by the MIIT.

The document also confirmed that China “will seek to further deepen cross-border audit supervision cooperation in a law-based and reciprocal manner,” and reiterated “China’s commitment to integrate with the global capital markets”. Amidst the heightened regulation, China continues to support both US-listed Chinese companies and its broader capital markets.

Moreover, both the MIIT and State Council’s timelines align with China’s political calendar. First, the Beijing Winter Olympic Games are set to commence in February 2022, which places a potential deadline on wrapping up new regulations. Second, in March 2022 the final meeting of the five-year session of the 13th National People’s Congress (NPC) is scheduled to occur. In this session, China will elect government officials for the 14th NPC.

During this time, China’s leaders will likely want to consolidate their agenda and demonstrate significant achievements for China’s citizens. Such recent achievements from the regulatory campaign include: easing the financial burden of tutoring, which accounted for a staggering 25% of urban household income9, supporting minimum wage for China’s 200 million gig-economy workers10, and addressing income inequality; Tencent recently pledged to contribute $15 billion to a social aid fund11.

As China’s leadership notches popular wins ahead of the NPC meeting, they have generated price pressure on China’s internet sector. As we have seen recently, any positive news about easing regulation leads to a spike in performance and vice versa. We believe China’s leaders will likely want to put new regulations and market volatility behind them well before the Olympics and the NPC meetings.

Is China explicitly targeting US-listed Chinese internet companies with new regulations?

Following the government-led cybersecurity review launched on DiDi Global shortly after its US IPO, many investors have asked whether we believe US-listed Chinese companies are being targeted specifically.

The short answer is no. What is happening with DiDi–which is not held in KWEB–is a separate issue and is exactly why the government halted Ant Group’s IPO in November 2020. The key difference is that since Ant was preparing to list in Hong Kong the regulators were able to prevent it from going public. Ant’s IPO prospectus included financials compiled from before new fin-tech regulations were introduced. If Ant had gone public before the announcement of these new regulations it would have likely had a detrimental impact on the stock, which is exactly what happened to DiDi. It is important to note that Didi’s IPO prospectus had 60 pages of risk factors. The government’s interest in enforcing new regulations is industry-wide not specific to US-listings.

Following the initial DiDi shock, it is now clear that the CSRC is actively working with US-listed Chinese companies to enhance their compliance with US regulation. Earlier in the month, the CSRC reinforced their support for US-listings, stating that Chinese companies should be free to list wherever they choose if they abide by the laws of both jurisdictions.

“It is our belief that Chinese and U.S. regulators shall continue to enhance communication with the principle of mutual respect and cooperation, and properly address the issues related to the supervision of China-based companies listed in the U.S., so as to form stable policy expectations and create benign rules framework for the market. The CSRC has always been open to companies’ choices to list their securities on international or domestic markets in compliance with relevant laws and regulations. Regardless of their listing venues, companies shall abide by applicable laws, regulations, and regulatory requirements in both their listing jurisdiction and operating jurisdiction.”

The CSRC’s comments were issued in response to a statement made by SEC chair Gary Gensler following the DiDi IPO. Gensler expressed concern over Chinese companies going public through Variable Interest Entity (VIE) structures in the United States without complying with China’s new guidance on cybersecurity reviews for companies raising capital through offshore entities. He also reiterated that investors should be aware that VIE companies are Cayman Island based shell companies and that there should be additional disclosure for VIEs. A VIE share certifies ownership of a contractual right to a percentage of a company’s profits, not ownership of a portion of a company itself, as provided by a traditional share of stock.

Based on these statements, we believe regulators in both countries are supportive of allowing Chinese companies to list in the United States but have a mutual desire to ensure there is transparency and that these companies comply with regulation.

How might KWEB be affected by the U.S. delisting legislation? Can you convert US-listed shares to Hong Kong shares for companies with dual listings?

Congress passed the Holding Foreign Companies Accountable Act in December 2020. The new law requires all US-listed companies to allow the Public Company Accounting Oversight Board (PCAOB) to inspect their audit books or face delisting. Since the law was passed, we have received questions regarding US-listed Chinese companies held within KWEB. We believe there are three key points to consider regarding the potential for delisting.

  1. There is a long runway before this becomes an immediate concern. Under the current law, these companies have a three-year window to become compliant. In a September Wall Street Journal opinion piece, SEC Chair Gary Gensler announced that the three-year timeline began this year, meaning that any delistings may commence in 2024.12 Recently the Senate passed the “Accelerating Holding Foreign Companies Accountable Act,” which would reduce the window to just two years. The bill has not yet been taken up by the House of Representatives13. There is a significant window for companies to come into compliance. We believe more open dialogue between the SEC and CSRC is likely based on recent statements.
  2. The SEC has proposed an orderly solution to the PCAOB audit issue. The SEC would allow a “co-audit” in which the US auditors of Chinese companies listed in the United States would be able to validate their Mainland subsidiaries’ work14. Most US-listed Chinese companies are audited by the “Big Four” US accounting firms: PWC, Deloitte, Ernst & Young, and KPMG.
  3. KraneShares can convert US-listed KWEB holdings to their Hong Kong-listed equivalents. Currently, about 64% of KWEB’s holdings by weight are comprised of US-listed Chinese companies15. Within the KWEB portfolio, Alibaba, JD.com, NetEase, Baozun, Baidu, Autohome, Bilibili, and Trip.com have secondary listings on the Hong Kong Stock Exchange (HKSE). If we were to convert all the dually listed names today, we could reduce the US-listed weight from 64% to 28%16. We have already seamlessly executed tests converting Alibaba US to Alibaba HK. While we are prepared to convert entire positions, we still hold US listings today due to their favorable liquidity, size, and lack of stamp tax. Additionally, in March of this year, the HKSE launched a consultation “to streamline the listing regime for overseas issuers and facilitate listing by companies listed on qualifying exchanges.17” This would relax the HKSE’s more stringent requirements and allow for Chinese companies currently listed in the US to relist in Hong Kong.

What do you think the parallels are between past regulations on internet companies versus now?

While today’s regulatory review is touching multiple companies within the sector, we have seen similar reforms in the past. Regulators restricted the approval of certain Tencent’s games in 2018 and curbed Baidu’s healthcare advertising in 2016. In both cases, the companies’ stock experienced short-term pressure but subsequently rebounded not long after.

In 2018, China spent months restructuring its approval process for new media (i.e. games and movies), maintaining policies restricting anything too violent or offensive for release. Ten months into the review, the newly formed Online Game Ethics Committee finally ended the suspension on new game releases. However, the freeze weighed heavily on Tencent, as its share price dropped roughly 30% over the course of 2018, losing more than $200 billion in overall value. Tencent was receptive to the Committee’s concerns and implemented new policies including mandatory identity/age verification and limits on younger users’ playtime. Subsequently, Tencent received a wave of approvals on new games, and the stock recovered in 2019.

Baidu’s 2016 advertising regulation followed a similar path. Regulators stepped in to make Baidu’s medical advertisements more transparent after the death of a student who underwent an experimental cancer treatment that he found through a non-disclosed advertisement on Baidu’s search engine. New regulation was introduced to clean up in-search healthcare ads and make it so the positioning of paid-for search ads of any kind could no longer be solely based on the highest bidder. Baidu temporarily halted its healthcare advertising and focused on revamping its policies to comply with the new regulations. Baidu’s sales were impacted in the following two quarters as healthcare advertising accounted for 20-30% of its overall search revenue at the time. In the long term, Baidu recovered, and its shares rebounded shortly after.

We believe these earlier instances of regulatory intervention offer insight into how today’s new rules may affect the sector. Tencent’s Q2 financial results released on August 17th highlight the continued success of the company despite new regulation; revenues increased 20%, games revenue increased 12%, FinTech revenues increased 40%, etc.18 The new regulation, which places stricter limits on gaming hours of children under 12, has an insignificant impact on Tencent’s business, as revenues from this age group account for just 0.3% of total gaming revenue. China’s main audience for gaming includes those between the ages of 18 and 35 (90-97%), who would not be affected by the regulation.

During Tencent’s Q2 earnings call, President Martin Lau directly addressed the current environment, stating that internet regulation is a global phenomenon as it has occurred in Europe and the US. Most importantly he’s “confident [Tencent] can be compliant” and will be a long-run beneficiary to regulation.

KWEB’s price-to-earnings ratio (P/E) has fallen dramatically. KWEB is currently at its most attractive valuation in five years.

KWEB has experienced periods of volatility in the past. While past performance is no guarantee of future results, each major contraction has subsequently been met with a period of even greater expansion.

Have any additional questions we did not address here? Please email [email protected] or get in touch with your client service representative.


Citations

  1. China Briefing, “A Close Reading of China’s Data Security Law, in Effect Sept. 1, 2021”, July 14, 2021.
  2. Reuters, “China passes new personal data privacy law, to take effect Nov. 1”, August 20, 2021.
  3. Tencent, “Tencent Announces 2021 Second Quarter and Interim Results”, August 18, 2021.
  4. Baidu, “Baidu Announces Second Quarter 2021 Results”, August 12, 2021.
  5. JD.com, “Quarterly Results”, August 23, 2021.
  6. National Bureau of Statistics of China, “Total Retail Sales of Consumer Goods Went Up by 8.5 percent from January to July 2021”, August 17, 2021.
  7. Ministry of Industry and Information Technology release on 7/9/2021.
  8. Bloomberg, “China CSRC to create conditions for audit cooperation with the U.S”, August 20, 2021.
  9. National Bureau of Statistics of China as of 12/31/2020, retrieved 7/28/2021.
  10. CBBC, “WHAT’S NEXT FOR CHINA’S GIG ECONOMY?”, June 28, 2021.
  11. Bloomberg, “Tencent Doubles Social Aid to 15 Billion as Scrutiny Grows”, August 18, 2021.
  12. Gensler, Gary. “SEC Chair: Chinese Firms Need to Open Their Books,” The Wall Street Journal. September 13, 2021.
  13. Reuters, “Senate Passes Bill to Accelerate Delisting Deadline for U.S.-Listed Chinese Companies”, June 25, 2021.
  14. WSJ, “SEC Pursues Plan Requiring Chinese Firms to Use Auditors Overseen by U.S.”, November 17, 2020.
  15. Data from Bloomberg as of 8/19/2021.
  16. Data from Bloomberg as of 8/19/2021.
  17. HKSE, “Listing Regime for Overseas Issuers”, March 31, 2021.
  18. Markets Insider, “Tencent Q2 Profit Rises; Total Revenues Up 20%”, August 18, 2021.

Term Definitions

Price to Earnings (P/E): the ratio for valuing a company that measures its current price relative to its per-share earnings (EPS).

Price/Earnings to Growth ratio (PEG): the ratio for determining a stock’s value which also factors in the company’s expected earnings growth.

Forward P/E: Forward price to earnings is a version of the ratio of price-to-earnings (P/E) that uses forecasted earnings for the P/E calculation.

KWEB Holdings Mentioned:

  1. Tencent (10.98% of KWEB Net Assets as of 8/18/2021)
  2. Alibaba (10.39% of KWEB Net Assets as of 8/18/2021)
  3. JD.com (7.60% of KWEB Net Assets as of 8/18/2021)
  4. NetEase (4.40% of KWEB Net Assets as of 8/18/2021)
  5. Baidu (4.25% of KWEB Net Assets as of 8/18/2021)
  6. Trip.com (4.23% of KWEB Net Assets as of 8/18/2021)
  7. Bilibili (3.49% of KWEB Net Assets as of 8/18/2021)
  8. Autohome (0.81% of KWEB Net Assets as of 8/18/2021)
  9. Baozun (0.32% of KWEB Net Assets as of 8/18/2021)
  10. ByteDance (0% of KWEB Net Assets as of 8/18/2021)
  11. Sina Weibo (0% of KWEB Net Assets as of 8/18/2021)
  12. iQiyi (0% of KWEB Net Assets as of 8/18/2021)

Holdings subject to change. Current and future holdings subject to risk.

Index Definitions:

The CSI Overseas China Internet Index: The CSI Overseas China Internet Index selects overseas listed Chinese Internet companies as the index constituents; the index is weighted by free float market cap. The index can measure the overall performance of overseas listed Chinese Internet companies. The Index is within the scope of the IOSCO Assurance Report as of 30 September 2018. The index was launched on September 20, 2011.