Going Home: An Account from China’s “Zero-COVID” Frontline

By Wenting Shen, CFA | May 19, 2022

Prior to COVID-19, Wenting Shen travelled to China regularly to visit managements of current and prospective investments. Round-trip travel to China from the US was impossible during the first two years of COVID-19, but recent easing of US travel restrictions encouraged her to plan a trip. With seats going fast, she snagged one on a flight from Newark to Shanghai for March 30. After three negative PCR tests over seven days at a Chinese-government-approved clinic in Queens, New York, she was ready to fly.

But days before Shen’s departure, new complications arose: outbreaks of the Omicron variant in several Chinese cities, including Shanghai, were prompting citywide lockdowns. The flight was still due to depart, but had been rerouted to Fuzhou, a coastal city across the strait from Taiwan, 450 miles to the Southwest.

The natural—some would say, prudent—decision at this point might have been to postpone her trip. But Shen, worried she might not easily get another ticket, pressed ahead. Here are her travel bulletins.

4 p.m. GMT March 31, 10,000 feet above Siberia

Quite frankly, it is a miracle we are still enroute to China. In recent months, many other flights were canceled minutes before departure, and some were turned around in the air midway. One woman I spoke with during my pre-flight COVID testing told me her ticket was cancelled eight times!

Assuming we make it (looking around now for wood to knock on—the plane is mostly carbon fiber), ours will be the first plane from the East Coast of the United States to land in China in weeks. When I booked my flight in January, my seat was one of the last available; a few days later all were gone from any airport between Boston and DC until the end of July.

I’m still amazed so many other people are intent on going to China right now, even though so many people in China are under mobility restrictions. The pandemic has occupied nearly every conversation I’ve had in recent days—with other travelers at the testing facility in Queens, at the airport, here on the plane with the friendly flight attendants smiling from behind their full hazmat garb. On the Chinese social media apps, there is furious debate between the “zero-COVIDers” and the “open-uppers,” just like the culture wars in the States. People in each camp are so busy arguing with and unfriending those from the other camp that a much-needed third voice is being drowned out—one that argues for hurrying more, and, if needed, better jabs into arms, especially for China’s under-vaccinated elderly, which might lower the severe costs of the pandemic to society.

4 a.m. local time, April 1, Fuzhou Changle Airport

The arrival process has been pretty orderly. After touching down, we were deplaned in groups of 15 so each of us could undergo testing and temperature checks. Everyone’s luggage was sanitized. We filled out forms capturing our identification information and phone numbers, which took several hours. Now we’re just waiting for a bus to take us to a quarantine hotel. Still don’t know the name and location due to rolling availability.

5:30 a.m. April 1, Phase 1, Day 1 of 15 in Room 919 at the Shiji Jinyuan Hotel, Fuzhou

We are settled in the quarantine hotel in Fuzhou, otherwise known as the City of Banyans because of all the beautiful banyan trees. The largest tree is said to date back to the Song era, about 900 years ago. It’s hard to make them out from my hotel room window, and I have no glimpse of the sea or Taiwan. I can see a little bit of the Min River, though, and the mountains to the north.

So far, the room is homey enough. I have plenty of space. The internet connectivity is subpar but functional. I have been staying in touch with my colleagues and talked to many people to update them on my arrival.

Temperatures are checked twice a day with COVID tests every few days. Thankfully, no one on my flight has tested positive. If that happens, our two-week quarantine will be extended even longer.

I received a call from the office in Beijing where my government ID is associated, since that’s where I went to college and spent my first job. The woman asked me a few questions about my plans and was pleasant, although I was a little taken aback by how happy she sounded when she learned I would not be frequenting her city after my quarantine. For a moment there, I felt like we were in the Black Plague!

7:30 a.m., Room 919, Day 2 of 15

Obligatory food review: The chefs are cooking for some 400 people, so the quality varies. At times the food is overcooked, presumably to kill any COVID floating around. But the delivery person has been exceptionally kind to me, usually leaving one or even two extra meals for me since I think my room, which is at the end of the corridor, might be the last one on his route. So, I save some choices that I enjoy. The meals are delivered to our door three times a day. No outside food is allowed, but online orders of daily necessities are permitted. For me, that’s a yoga mat, which I ordered from Taobao. Hoping that yoga will help me restore my circadian rhythm.

11 a.m., Room 919, Day 6 of 15

My fellow passengers and I (we are all in a WeChat group together) have been scrambling this morning to figure out the next leg of our travel. April 16th now appears to be our release date from Phase 1 of the quarantine period, which still seems very far away. What is not clear is the latest policy for Phase 2 in Shanghai, which many of us have listed as our final destinations. I don’t know yet whether I will be at a central government-operated quarantine hotel as I am now, or self-quarantining at another location, which would be strictly monitored. The situation is very fluid.

9:30 a.m., Room 919, Day 8 of 15

Half of my Phase 1 quarantine time has passed, and it looks like spring has arrived here in Fuzhou—the views are pretty, and I wish I could go outside to explore. Unfortunately, the bright sun doesn’t lift the spirits of the passengers from Flight MU588. As time grinds on, people have become a bit more anxious and exhausted. On WeChat, there are complaints about the hotel rooms and services. A few people feel the meals are unpalatable and would rather have cup noodles. Others grumble about the brain-stir-style COVID tests or the internet service, which has degraded with a new influx of passengers at the hotel. I’ve stayed out of it (maybe the yoga helps) and appreciate how tough it must be to keep 400 quarantined people happy. I have been able to stay connected to the internet most of the time but am having to use my phone hot spot more.

Our biggest worry is what will happen to us after Phase 1. The barriers seem more insurmountable by the day for those who were headed to Shanghai. Apparently, most flights and trains to the city have been canceled, so some people may have to stay several more days, or even weeks in Fuzhou. There were stories of people turned away at the Fuzhou airport for departure—but then rejected entry back to the city, so they have no choice but to sleep at the Fuzhou airport (which might be apocryphal since I didn’t see anyone camping out when we were there). The same struggle is shared by those trying to make the trip the other way—those who landed in Shanghai but are trying to get to other cities outside. A friend of mine has been trapped in Shanghai for three weeks. He has spent the first two weeks in quarantine, and the hotel where he is staying has just announced the food is running short. At least I have other options, including heading straight on to my hometown Xi’an.

2 p.m., Room 919, Day 9 of 15

We are the lucky ones. None of our little headaches here in Fuzhou come close to what people in Shanghai are experiencing, who have now been in lockdown for weeks. They are panicking about food, and more and more items are under shortages. I know from my conversations with our portfolio companies that much of this has to do with logistics—countless restrictions have been placed on truckers and drivers, who cannot come into the city because of the fears they will bring in or carry out the virus. At times, this feels like the country is living backwards, plopped right back at the start of the pandemic two years ago. I spoke with one of our companies, the travel booking site Trip.com Group. They think more cities will enter lockdowns in Q2 because of the appearance of Omicron everywhere.

10 a.m., Room 919, Day 11 of 15

I’ve spent the last couple days speaking to more companies and hearing more difficult news from friends and family throughout China. A friend was placed in quarantine simply because someone else in his testing batch was positive, and they wouldn’t readminister tests to find out whose sample it was.

When I put my analyst hat on, all this makes me think that the current wave could leave worse marks on the economy than 2020. If cities have recurring lockdowns, multinationals might re-evaluate China’s comparative supply chain advantages. And orders have been lukewarm anyway, as more of the world resumes normality and moves more aggressively to insulate itself from any potential disruption.

11 a.m., Room 919, Day 12 of 15

Out of everything gloomy, a piece of positive news! Some cities are finally pushing more seriously for vaccines for the elderly. In Beijing, a generous gift credit of Rmb500 (US$75) is being handed out to those above 60 years old who get a shot, along with additional coupons for those who bring in their friends.

My 88-year-old grandparents finally got their first shots a couple of weeks ago. Like any good granddaughter, I had bombarded them for several weeks with severity and death data from the unvaccinated elderly in Hong Kong. Now, they’re waiting for their second shot. Already, it gives me some peace of mind—and hope they are a representative indicator!

10 p.m., Room 919, Day 15 of 15

My two weeks of quarantining in Fuzhou are nearly up—at times it has been slow, but the days have been very busy for me—earnings season, talking to companies to let them know I am here, comparing notes with colleagues. It’s nice to be able to attend so many of my company discussions without a time zone difference, although none seem to be doing in-person meetings just yet.

I can’t say this is the finest hotel I have ever stayed at, but it is sure to be the most memorable. For one, I won’t forget the silent humor of the staff. One fellow passenger complained that her meals were too bland and asked the hotel to cook with more soy sauce. The next thing she knows, she gets a bottle of soy sauce delivered to her door, a sly invitation to douse her own food all she wants. It’s the amusing moments like these that have made this time a little easier.

Now, only nine hours to go before my release from Phase 1. Medical assistants dressed in white protection gear (nicknamed “Big White” on Chinese social media) come to test my hotel room. Swabs are taken from my pillows, my jacket, and my toothbrush.

As lockdowns dragged on in Shanghai and spread to my other intended destination, I have decided to head straight home to Xi’an after all. The only downside is that none of the six people in my family will be allowed to leave the apartment for the first seven days I am there. After a week, they will be granted freedom to move around, but I’ll have to stay inside for another seven days. Hopefully my grandpa’s snoring won’t disrupt our firm’s quarterly webcast, which we are filming a couple days after I arrive.

9 a.m. Xi’an time, April 17, Phase 2, Day 2 of 14

Home at last! I left my quarantine facility on Saturday as planned—the trip to Xi’an took twelve hours. The climax was the ambulance ride to my parents’ from the airport (that’s me again to the left, mildly offended no sirens are blaring). When I finally reached home, a local officer in Big White was waiting for me. She was carrying a seal for the front door and an electronic lock that will send an alarm to the local police if any of us ventures outside more than three times a day for more than the few minutes it takes to carry out the trash or get tested.

Ours is a kind of double lockdown—one protecting Xi’an from me due to my arrival from abroad, the other a citywide lockdown protecting us from the virus now loose on the streets of Xi’an.

Evening, April 23, Day 8 of 14

I continue to have daily calls with companies. From my conversations, logistics and travel seem to be front-and-center in their concerns. Since logistics companies are often faulted as carriers of the virus, the new default is to suspend deliveries as soon as a lockdown is commenced.

Consumer sentiment is weak now too, which may scar the consumer and retail sector even after the peaks have passed. Staples like dairy should be doing fine. People are still trying to eat and would like to buy!

Industrial disruptions are occurring throughout the supply chain, which could do long-term damage to China’s status as the world’s factory. So ironic after China was the first country to get back up and running during the first wave, and so sad since it seems like so much of the damage could have been controlled.

Noon, May 1, Reflection and release

During this entire trip, I have felt extremely privileged. For the duration of my quarantine, I have always had more than enough to eat, unlike all those many isolated and hungry in Shanghai. I also feel a little guilty about the inconvenience my return has caused others. I learned the hotel staff was in their own parallel lockdown with us, working at the hotel for up to a month and then quarantining for 14 days after each shift. The flight attendants have been quarantining for 14 days after each flight.

I’ve started to wonder how the country’s near-term growth targets can possibly be met now absent a relaxation of Zero- Covid and/or massive additional government support. I understand that they wanted to both protect the elderly and other vulnerable people and give the local biotechs a chance to finish developing their own mRNA vaccines before letting in the Western versions. But couldn’t there be a more sustainable way to handle the situation?

One thing is certain—the government is at war with the virus, but there’s also a war underway within public opinion. In the chat groups and social media sites where I’ve spent so many of my waking hours these past five weeks, it is constant debate. This lack of solidarity and wavering of confidence that we will get through this is a stark contrast to China’s fast emergence from the pandemic in 2020 and has undoubtedly contributed to the difficulties. On the other hand, there is also something refreshing about it—a sign of civic sanity, perhaps, in the face of lockdowns on top of lockdowns.

According to reports a few days ago, another 1,100 companies in Shanghai have been cleared to reopen. That’s on top of the 600 that were previously announced. The latest estimates are the whole city might be out of lockdown within two weeks. We’ll see. Here in Xi’an, meanwhile, we have gotten off easy. I was finally sprung right before China’s five-day “May First” (Labor Day) holiday. The last week actually worked out pretty well for me, because April 30 is the deadline of the super reporting season for A-share companies, who usually report both annual and Q1 results simultaneously and hold their annual investor meetings, the vast majority online. I managed to attend as many as seven meetings per day. I hope my boss doesn’t get any ideas about putting me in quarantine every earnings season now.

During the holiday, I was able to catch up with a handful of schoolmates since nobody could really travel outside the province. Interestingly, most have ended up working for state-owned enterprises or institutes. The recurring complaints seem to be around compensation and the rigidity of the system. Otherwise, people still worry about the same things as before: housing prices and kids’ education. There still seems fierce competition to get into a good school to test well for the college entrance exam.

Over this past weekend, I took my first long walk in Xi’an in several years. The city has transformed from the historical city I remember into a cosmopolitan metropolis with thousands of high rises and dozens of brand-new shopping malls. As I walked around the new South Lake that was being built when I left for college, early risers were doing their morning exercises. Life was remarkably calm and peaceful. Nobody seemed to care about politics so long as it is leading them to a brighter future—and hopefully a future that doesn’t have to involve repeated lockdowns.

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What’s Driving China’s Regulatory Transformation

By Lee Gao | November 05, 2021

On the surface, there are few precedents for China’s quick-fire regulatory changes, which over the past few months have transformed everything from e-commerce and education to health care and real estate.

One can only speculate on the reasons for this synchronous timing, but one possibility that stands out is the confluence of the five-year policy and leadership cycles in China. This is the first year of the 2021-25 Five-Year Plan, but more importantly, it is the final full year before the top 200 or so members of the Central Committee of the Communist Party of China are selected at its National Congress in October 2022. It bears remembering that those politicians are similar to counterparts elsewhere in facing challenges that have diverted them from other priorities. They spent the first two years of their terms coping with escalating US-China trade tensions, and just when “normal order” loomed after the signing of the Phase One trade agreement, COVID-19 hijacked everyone’s lives. Only recently have they gotten a chance to work on much-delayed goals.

As policymakers picked up where they had left off, they found themselves facing stakes heightened by the pandemic: stagnating incomes, weak consumer confidence, and a growing demographic crisis as birthrates continue to decline. These challenges may have accentuated their top priorities, ones that have been repeatedly highlighted in official policy statements over the last few years: innovation, rule of law, culture, the environment, and social harmony.

The fact is that ever since Deng Xiaoping initiated the initial series of capitalist overhauls in the 1980s, China has undergone multiple periods of reform. These changes cut a wide swath across economic activity and drastically curtailed certain targeted sectors. They were painful in their time, creating mass unemployment and fueling social discontent. Ultimately, they laid the groundwork and helped sustain several decades of nearly uninterrupted growth.

Previous reforms were far less visible to foreign observers because they barely touched the companies widely held by global investors at the time. For example, the coordinated supply-side reforms of 2015, undertaken in part to reduce chronic pollution, shuttered roughly one-fifth of China’s steel capacity (equivalent to Japan’s entire steel output) in under two years. Air quality improved dramatically, while bankruptcies almost tripled as many marginal producers were killed off. But not many foreign investors owned marginal steel producers, preferring to own faster growing companies such as Alibaba and New Oriental. Likewise, the anti-corruption campaigns that began in 2013 may have ushered in a more sustainable business environment, but they were terrible for liquor makers, whose products had become popular high-priced gifts to lubricate business deals and lobbying efforts. Kweichow Moutai, producer of its fiery namesake liquor, saw its sales growth plummet in 2014 and 2015, but the company was not nearly as widely owned externally as Tencent is today.

Much of the focus of late has been on one policy priority: common prosperity. Redolent of China’s collectivist past (the term was first used by Mao in 1950), the phrase frightens some foreign investors who are unsure which companies’ prosperity will be sacrificed at the altar of the commons. Yet policymakers have been clear: their focus is on growing middle-class disposable income, not “robbing the rich to help the poor,” according to Han Wenxiu, executive deputy director of the General Office of the Central Financial and Economic Affairs Commission. This overt aversion to a European-style welfare model may seem contradictory for a party that still pays lip service to its Marxist roots. But the reality is that China systematically underinvested in education, health care, and other social spending—especially in rural areas—as it sought to catch up economically with more developed economies. Until now, policymakers have done little in the way of redistribution; indirect taxes, which generally serve to widen income inequality, still represent two-thirds of fiscal revenue. With China coming into its own, we should expect its practices to converge with those in more advanced economies, including some form of income and wealth redistribution.

To my mind, these regulations are reminiscent of the US Progressive Era of the late 19th and early 20th centuries, epitomized by Theodore Roosevelt’s Square Deal.

In practice, the government’s targets for common prosperity—judging from recent policies and the detailed roadmap for its first pilot program in Zhejiang, the richest province in China and home to Alibaba—are education, health care, and housing. In these pivotal areas, structural impediments have exacerbated inequalities over time, producing a set of challenges that would be very familiar, for example, to residents of California. One of the more draconian national policy shifts, which recently consigned much of the private after-school tutoring business to the non-profit sector, does not go as far as South Korea’s complete ban of private tutoring in the 1980s.¹ In each country, the reforms were designed to ease the burden on parents who spend up to thousands of dollars each month coaching their children on how to pass exams. (To put this cost in perspective, the Chinese city with the highest average annual per capita disposable income in 2020 was Shanghai at $11,000.) Likewise, China’s recent online regulations covering antitrust, data security, and the safety of minors are similar to the concerns of consumer advocates everywhere.

To my mind, these regulations are reminiscent of the US Progressive Era of the late 19th and early 20th centuries, epitomized by Theodore Roosevelt’s Square Deal. It was not an easy time to invest and was marked by muscular antitrust interventions, the inception of a progressive income tax, and the appearance of the first federal consumer and environmental protections. Certain industries faced a permanently higher level of regulation with which they had been unfamiliar. But many companies thrived, and the reforms arguably laid the foundation for a century of growth that shaped the American economy into the largest in the world today, home to the largest number of globally competitive companies.

Structural changes of this magnitude will inevitably shake up competitive forces, buffeting the outlook for growth and strength of free cash flow generation for many businesses—but not all of them in negative ways. If China’s reforms succeed in improving middle-class disposable income while opening more opportunities for more people and still ensuring that the country remains a meritocracy, the government will have set the stage for more sustainable end demand for many industries. It’s a tall order, but one notable advantage enjoyed by Chinese policymakers today is the benefit of a century of hindsight observing which policies worked—and which did not—in the countries that have tried them.

Endnotes

This commentary is excerpted from the Harding Loevner Third Quarter 2021 Global Report.

¹The South Korean ban was ultimately overturned by the courts two decades later, though South Korea’s government has been adding new restrictions on tutoring ever since.

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From A to Xi: Regulatory Risk in China

August 12, 2021

Recent changes in the regulatory environment in China have sparked questions and debate about the future of investing in the country, both among people in the wider world and inside Harding Loevner. On August 4, 2021, we hosted a special webcast that featured a lively discussion about these issues. A complete video replay of the conversation is above, but if you prefer to read what was said, a transcript of the discussion follows below. The answers have been lightly edited for clarity.

Ferrill Roll, CIO: We’ve convened this discussion because after coping with four years of US-originated turbulence in Chinese equities—from tariffs and trade wars, to congressional action against Chinese companies listing in the US that hadn’t gone through the usual US auditing requirements, to executive orders prohibiting Americans from owning companies controlled by the Chinese military—we are now faced with turbulence in Chinese equities that has originated from Chinese regulatory actions. In that new, different environment, we thought it would be useful to discuss how we cope with this, what’s actually going on, and what our thinking is for the future.

First, I’d like to comment about our risk guidelines at Harding Loevner. We insist on diversification in all our strategies. And insofar as that pertains to Chinese equities, you will recall that it was just a year ago that we were in lively discussions about the limit that we had placed on Chinese equities—in our Emerging Market Equity strategy in particular but, in fact, in all of our strategies. We had set our limit—when times were calm, and we were being thoughtful about the future—at a maximum weight of 35% in China for a diversified emerging market portfolio.

When China managed to get the coronavirus under control faster than the rest of the world, Chinese shares surged relative to everywhere else. Our emerging market PMs were chafing under the inability to own as much as the index, let alone go overweight, in China. Clients were asking us questions about how we could be so ultra-conservative as to constrain our PMs from doing whatever they needed to achieve returns. And, frankly, we had rather tense discussions among our partners as some clients thought about leaving Harding Loevner as a manager because of our intransigence over these risk controls.

We think of our risk controls as constraints against our future selves—in the way that Ulysses tied himself to the mast before he passed by the sirens that would otherwise have lured him to destruction. We thought when we were setting our limits on China that they were sensible. A year on, we are now flooded with client calls about, “How much risk do you have in China? What are your exposures to the companies being buffeted by these regulatory shifts?” And we feel vindicated that we stuck to our pre-commitments. This is a well-established area of behavioral finance, that pre-commitments are the hardest things to keep when they are the most important things to keep. I think this is a lesson that we will take with us through the years going forward.

That said, Harding Loevner has a very clear long-term outlook that China is going to be a fruitful place to invest our clients’ money and to hopefully add value using our process of fundamental analysis and valuation. We launched our first single-country strategy, the Chinese Equity strategy, late last year. So, we’re optimistic that we will find lots of ways to add value in China.

Pradipta, you’re the Lead PM for the Chinese Equity strategy. Your entire portfolio is subject to these recent regulatory shifts. Why don’t you give us a quick summary of what’s happened recently and how it’s affected you?

Pradipta Chakrabortty, Lead PM Chinese Equity: So, there have been a slew of regulatory actions across different sectors and industries. I classify them under four buckets. First were the antitrust regulations that manifested through fines on Alibaba and moved on to fines on other companies in the internet space such as Tencent and Meituan. That has subsequently moved on to breaking down several barriers and walls that these gigantic platform companies had created around themselves.

The second bucket relates to the stability of the financial services sector and was manifested through regulations that resulted in the cancellation of the Ant Financial IPO. The third area, data security regulations, is much more recent. Immediately after the IPO of the ride-hailing service Didi Chuxing, you saw cybersecurity concerns emerging, leading to restrictions of Didi’s ability to onboard new users. And the fourth bucket, social issues-related regulations, is pretty broad across different sectors. One of those sectors affected was after-school tutoring, where you had severe restrictions, converting that industry into not-for-profit. This week, we saw news about concerns about how online gaming affects children. So that sector has been under a little bit of pressure. There’s also been noise around the gig economy and fair compensation for workers there.

So, it’s a whole gamut. The net result is that investors have been spooked. The MSCI China All Shares Index is down close to 8% in the first seven months of the year, underperforming the MSCI ACWI Index, which is up 13%.

FR: Jingyi, can you talk to us about the high-level goals the Chinese government is pursuing with all these changes?

Jingyi Li, Co-Lead PM Global Equity: The Chinese government’s long-term goal is to continue to develop the economy. It has done a good job leading China from a low-income country decades ago to where it is a mid-income country today. And it has showed the ambition to continue to grow the economy in the next decade or 15 years to become an entry-level developed country. That means the economy needs to grow around the mid-single digits for the coming one or two decades at least.

To continue to drive the economy to reach the next level, you need a lot of structural reforms, reforms that we have seen, but also at the same time, you need to address a lot of social issues. Some are social issues caused by new economies and new technologies. Some are common issues everywhere in the world, like inequality, like the competitiveness of the labor force. Without addressing these kinds of long-term profound social issues, the Chinese government—who rely on long-term growth as one of the key legitimacies of their government—is concerned that they may not be able to continue on this trajectory, just like many Latin American countries stuck in the so-called mid-income trap.

FR: Craig, would you agree that’s the main goal, or do you think there are some more jaundiced, pernicious goals that the government is pursuing?

Craig Shaw, Co-Lead PM Emerging Market Equity: China is run by the Communist party. It is not a democracy. You could call it a dictatorship, and the way they stay in power is by keeping people happy. There’s an old Chinese saying that the emperor will reign in heaven until the people throw him out. And that’s proven to be true over much of China’s history. They are doing their best to stay in power and keep their people happy, which is something we always have to be cognizant of.

There’s an old Chinese saying that the emperor will reign in heaven until the people throw him out. And that’s proven to be true over much of China’s history.

FR: So, you don’t think they’re going after companies that have skirted the domestic listings rules by raising money outside? You don’t think they’re targeting prominent individuals who made a lot of money and turned that into a personal soapbox for their own use?

CS: Well, those are issues. We’ve seen this over the decades in emerging markets. Remember how in Russia Mikhail Khodorkovsky at Yukos got involved in politics and lost everything and was in prison for quite a while. To a certain extent, if someone becomes influential and wealthy and powerful, they are perceived, whether they really are or not, as a threat to the government’s control over the population. It’s a risk. We certainly saw that with Jack Ma at Alibaba a little while ago, when he made some comments about the future of finance in China. And the powers that be didn’t seem to like it.

FR: Andrew, before you became Co-Lead PM of the International Equity strategy, you were the manager of research. In fact, you started at Harding Loevner as an emerging market analyst. So, you’re deeply familiar with how we think about regulation in the structure of our research process. Can you lay out for us how we assess regulation?

Andrew West, Co-Lead PM International Equity: Sure. We have three key features of our process that leads to us being aware of regulatory risk and reacting to it, and hopefully anticipating it. One is our constant analysis of Porter’s “Five Forces” that dictate industry structure. For each of the five—whether it’s bargaining power of buyers or suppliers, rivalry, threat of new entrants—we ask our analysts to both understand the existing regulatory issues that may influence those forces and to keep an eye out for incoming potential changes that could influence them. It’s all part of helping us understand the trajectory of profitability in the future, of growth opportunities, and helping us reflect that in our forecasts. The second key feature is our ongoing monitoring of environmental, social, and governance (i.e., ESG) risks. And third is our requirement of higher returns from riskier countries, where we tilt our valuations of stocks based on the riskiness of the countries in which they’re operating.

FR: I’m interested in the ESG analysis. At Harding Loevner, ESG analysis is really a risk analysis rather than a pursuit of return of goodness, if you will. We’ve had a lot of client inquiry over the last two years about the E part of ESG, and almost no inquiry about the S—the social part. Do you think that we have underemphasized the regulatory risks that have emanated from these social risks in ESG in the case of China?

AW: It is a topic that we have actively debated. And social risk is a risk. A lot of the concern has been around looking from the outside in, with international companies and other countries threatening China in some way over their internal political activities. But there are also internal social pressures inspiring new regulations. And that ties into what Jingyi spoke about before, when you asked him about the goals of the Communist party.

Have we under-recognized it? I would say the market has revealed an under-recognition of regulatory risk. Just a year ago, there seemed to be no fear built into prices. And now there’s a lot of fear built into prices. Awareness of that comes and goes. I think the actions in some industries were harsher than just about anybody would have forecast. Even if we’d been aware of the pressures for change, we may not have anticipated such sudden and violent regulatory reaction to those pressures.

I would say the market has revealed an under-recognition of regulatory risk. Just a year ago, there seemed to be no fear built into prices. And now there’s a lot of fear built into prices.

FR: Pradipta, in addition to your new role as a Lead PM of the Chinese Equity strategy, you have long been Co-Lead PM on the Frontier Emerging Markets Equity strategy. You’ve invested in a bunch of countries that have a lot of risk. How do you assess risk in China versus the regulatory risk in China versus the regulatory risk in, say, Turkey, which has an authoritarian president?

PC: I mean, Turkey is obviously a different case altogether. You can’t really put it in any bucket. But in several other frontier countries—Kenya, Nigeria, the Philippines—they all have a significant amount of regulatory risk, and we’ve seen regulatory actions in those markets. The difference is in terms of the communication and the transparency of the debates that go on in the public domain. In most of these other countries, you would see lawmakers and regulators going through a lot of public debate where you’re privy to their thoughts and their potential future actions, much more than you would in China.

But to be fair to the Chinese regulators, there have been hints about each of these regulations that have been enacted this year. The problem is that those clues have been rather cryptic and the end result quite shocking. For example, the after-school tutoring sector having been converted into a not-for-profit—there was really no clue about that coming. So, I would say communication is where there is definitely more work to be done by the Chinese regulators. If they do communicate their intentions or their thinking more clearly, there would be less disruption in the markets.

FR: Craig, you mentioned Russia and the case of Yukos and the expropriation of assets in that case. That was at least as shocking as the vaporization of billions of dollars of market value of these Chinese education companies. How do you think about risk in China versus regulatory risk or expropriation risk in Russia or any other of the emerging market countries that you’ve invested in over the last 20 years?

CS: China’s a little different. You can argue how effective democracy is in some of the emerging markets, but at least they are democracies, to some extent. Whereas China is not. And so, the government has total control over everything. They debate within themselves, but as far as dealing with representatives of the populace, it’s a little different. They have a lot more control and a lot of these moves that we’ve seen are all about enhancing that control.

If you look at Russia, it’s changed quite a bit over the years. There was a time that share prices would fall 20% if Putin was annoyed with something. Certainly, Putin has a great amount of control over what happens. But he has not been overly aggressive in terms of doing anything to industries. I mean, if you go back to the Yukos case, there was an arrangement made a long time ago when Putin first came to power, that he would let the oligarchs keep whatever they managed to gather during the chaos of the fall of the Soviet Union as long as they stayed out of politics. And to a large extent, he’s kept that promise. But he certainly can scare people.

FR: Presumably, you’ve come to rely on that, because you’ve been overweight Russia in your emerging market portfolio for five years.

CS: Yes. It’s not the easiest place to be, but we do what our process and philosophy guides us to, and have found some good quality-growth companies at reasonable prices.

FR: It’s one thing for emerging market or frontier emerging investors to parse these risks because they’re all risky neighborhoods, and each one is risky in its own way. But Jingyi, you’re now a global portfolio manager, having concentrated on China for a long time as analyst. How do you compare the regulatory risk in China versus the regulatory risk in the US?

JL: I think the regulatory system in the US is much more mature and proven to be better for entrepreneurs and innovators, very good and reliable for business, and, of course, very favorable for investors, especially long-term investors like us. Speaking of the regulatory risk, I would also like to point out the risk of not taking actions on some of these long-term issues. Because when we talk about cybersecurity, antitrust, all kinds of social issues—these are not specific to China. These are very common issues in every part of the world. The US is trying to address them. Europe is trying to address them.

If other countries are not able to take on these issues in sensible and timely ways, they will have challenges, and their long-term economic development eventually will affect the return of long-term investors like us. Also, there’s a question of how much regulatory risks have been discounted in the current stock crisis. In the past several months, obviously, the market has been more alert toward the regulatory risk in China. Maybe that’s sufficient, maybe that’s over-reaction. But in other parts of the world, in other markets, maybe the regulatory risks have not yet been fully discounted yet.

FR: How about it, Andrew? Are the price changes in Chinese equities causing you to be more interested in Chinese equities? Or does the scope of the regulatory risks cause you to be more cautious?

AW: It’s a tug of war. On one side, risks have risen, I think. Or the awareness of risks that were there have crystallized. And we don’t know exactly how much more is to come. My suspicion is that there might be a slowing down, but that’s not for sure. On the other hand, there’s definitely more risk discounted than before. So, on the one hand, you’ve got maybe some concerns about future margins, future growth for some companies. On the other, a lower price.

The International Equity strategy, which you and I are Co-Portfolio Managers of, has been underweight China for the past several years as China has risen in terms of the index weight. And that was modestly negative for us when Chinese stocks were going up. It’s been favorable for us as the market has declined recently. And so, we are looking at whether to add new securities or add to some existing securities that have become cheaper relative to fair values. My natural tendency is to be fearful when others are not, and to be less fearful when others are more. So, I would say, I would be looking to reduce that underweight on the assumption we find some securities that are over-discounting risk and under-appreciating long-term growth and profitability.

FR: Craig, you were chafing under the limit of 35% in China. I happened to check this morning. China is now less than 35% in the MSCI Emerging Markets Index. Are you more inclined to buy? And will you go overweight now than you can?

CS: We are doing the same thing we’ve always done—looking for quality-growth companies at reasonable prices. Andrew said it very well: It’s a tug of war. And it’s always been like that. Some of the changes that have come around the last few months have made it a little more challenging, but our reaction has been to purchase more Chinese equities. We had five purchases in the second quarter. Four of them were in China in response to 1) new ideas from our analysts, and 2) lower share prices and valuations. This is what we do. It’s not always easy. Sometimes it’s not fun.

Some of the changes that have come around the last few months have made it a little more challenging, but our reaction has been to purchase more Chinese equities.

FR: Pradipta, you have no choice but to invest in Chinese companies in the Chinese Equity strategy, but you do have choices between industries. Are there industries at this stage that you would avoid, other than the obvious one of the tutoring industry?

PC: Picking up on the ESG front, we’ve always considered ESG risk in these companies, and I think the social element has to be increased.

When I look at it through that lens, there are sectors like the property development sector, for example, where after the recent Politburo meeting there was talk about how housing is for living, not for speculation, right? Those kinds of comments give you hints that there are more regulatory strictures to come.

FR: Isn’t Harding Loevner generally biased against property development in the first place?

PC: Yes. So, that’s an industry thankfully we don’t own right now. We don’t want it because of quality and growth reasons, obviously. But then, there is another layer of risk that is coming.

FR: Confirming our bias against it.

PC: Yes. But I would also be very cautious about some of the other sectors where we do have stocks, like Health Care. Under the social equality principle and health care affordability for all, I would think—especially generic drugs, which have lower content in terms of technology and innovation—those probably are at risk of further price compression. Then the anti-trust regulations are breaking down barriers, which are changing industry structures from what we knew them to be a year back.

So, from the point of view that Andrew talked about earlier, the Porter structure is changing. We need to re-look at the growth cases. We need to re-look at the competitive advantage cases for some of our companies. And then act accordingly. Optically, the valuation might have become better. But in some cases, the valuation may not have become as much better as it seems.

FR: Jingyi, are there industries you have increased your aversion to in the last couple of months?

JL: The short answer is no. I don’t see any sort of a wholesale attitude change to any particular industry. That said, we need to look at our business from an ESG angle, especially the social angle, in a deeper and more profound way. We need to try to understand the social implications of their business models and to think about whether there’s any very profound social impact we should be aware of.

You asked about the sectors to avoid. I should point out that higher regulatory standards, or standards for social awareness, could also open investment opportunity in companies that are more aware of those issues to begin with, or with the management teams who can do a better job to adapt to these kinds of requirements, or even companies that provide solutions to address some of the social issues. So, all these regulatory changes may also provide us some interesting new investment opportunities, again using our fundamental Porter lenses and ESG frameworks.

FR: I’m going to sum up, and then, we can get to questions from outside. As Andrew pointed out, we explicitly try to assess regulatory risk in the framework of our research process, through the lens of Porter’s Five Forces. And I think importantly, we do have a culture of debate between analysts—between PMs and analysts, between people who know a lot about China and people who have questions about China—and that culture of debate is a very active part of getting to the underlying truth of what’s going on. The third thing I would point out is that the insistence on diversification in all our investment strategies is something that we are deeply wedded to, as I alluded to at the start when discussing the nature of pre-commitments.

I think ESG is getting a new take that is reinforcing our belief that ESG risks are exactly that, and that the way we’ve embedded ESG analysis into our research structure is the right way to approach the whole set of issues. And then, finally, the price declines in these Chinese equities are giving us a chance to reassess each of the companies within our coverage and ascertain whether future returns are higher because the prices are lower, or the prices are accurately reflecting the new risk. That is a company-by-company and stock-by-stock issue that we are actively engaged in right now.

Audience Question: Can you comment on your current views on VIEs and whether the VIE structure is at risk due to some of the regulations and regulatory changes that have come out of China?

FR: I’ll take that one. VIEs, for those who don’t know, are variable interest entities, which are special purpose vehicles that connect US-listed stocks to domestic Chinese businesses through holding companies and some third country and equity swaps to get the returns connecting the two.

We have long viewed VIEs as a precarious legal structure and, therefore, set limits on how much each strategy could invest in VIEs. Nothing in the current imbroglio of regulatory shifts affecting the share prices of companies utilizing VIEs has made us see VIEs as more risky or less risky. In our view, the precariousness lies in the legal structure itself and our limits on VIEs are not changing.

I would say that there is debate internally about whether Chinese authorities have, in some sense, blessed the VIE structure by allowing what are called CDRs—a Chinese equivalent of ADRs whose primary listing is a VIE—to be listed in domestic exchanges in China. While that gives some comfort, it’s a regulatory rather than a legal backing, in my view, and in the view of our legal experts.

I was also troubled by statements out of the recent Politburo meeting. I only get translations, but one of the statements was that “the Politburo is going to improve overseas listing supervision.” We’ve had the phrase “rectify” applied to several of these industries where regulatory changes have occurred. I’m uncomfortable with this word “improve” because it sounds a lot like rectified, which could be damaging. Jingyi, how would you characterize that phrase? What do you think it means?

JL: Yeah, I’m really reading the tea leaves here, but my understanding of this phrase, which is very interesting, if not important, is that the policymakers still understand the necessity of a VIE structure …

FR: In order for Chinese companies to raise capital abroad?

JL: To raise capital. They fully understand the historical background going back in the early 2000s. There are long debates inside China on what to do with the VIE structure, but, after all these years, I do not think they have taken a hostile view on this.

The reason that we have a change is they are always worried that some companies may abuse the structure. And that’s why they think they need to take a more active role to supervise Chinese companies that use it to get listed. It’s fine to use that structure, but it’s not fine in their eyes to use it to circumvent some of the regulatory frameworks that are in place to prevent some companies from doing certain things. That’s my understanding.

Audience Question: Why invest in China at all?

AW: We’ve invested in a lot of risky places and we’ve made money in a lot of risky places over the decades. As we said, we don’t get paid for being comfortable. China represents roughly 10% of the international index. Our analysts have found over 50 companies that meet our pretty high standards for quality and growth.

So, we think there are companies out there that are attractive, not just relative to other Chinese companies, but on a global basis. That is the opportunity. And then there’s dealing with the risks of it. That’s something that we’ve done for decades. We very rarely rule out any country’s securities. As I mentioned earlier, we may require higher returns to compensate us for the risks that we take, and we are intelligent about diversifying those risks as well.

We think there are companies out there that are attractive, not just relative to other Chinese companies, but on a global basis. That is the opportunity. And then there’s dealing with the risks of it. That’s something that we’ve done for decades.

PC: If I may add, as a market, China is massive with huge consumption opportunities that are transforming in a significant way. But, relatively speaking, there are pockets where the risk is lesser and much more aligned with what the government is trying to achieve in terms of its national and overall social objectives.

The massive production base in China is also transforming through the increasing penetration of automation. This entire area is one where we find very, very high-quality companies which are rapidly growing. Electric vehicles and their value chain are another area related to that and one which is very well-aligned with the government’s carbon neutrality goals. China has the largest value chain as well as some of the biggest consumer demand for these cars.

So, there are those pockets that continue to be very, very high-growth and have very high-quality companies that meet our requirements and are very attractive from a long-term point of view. Especially in a country which is right now going through a massive transformation.

What did you think of this piece?

Too Much Information

By Simon Hallett, Vice Chairman | March 03, 2021

In the late 1950s, in his book Common Stocks and Uncommon Profits, Phil Fisher recommended making investment decisions based on “scuttlebutt,” the kind of information an investor could get by asking around. This entailed tracking down and interrogating customers and competitors, employees, and former employees. Doing research, in the sense of gathering evidence and analyzing it to reach a conclusion, was hard work, but enabled analysts committed to such intellectual labor to obtain an edge over their competitors simply by having better, and more complete, information.

Indeed, when I started my career in investing in the late 1970s, obtaining even basic financial info about a German car company still required going to Germany and knocking on the company’s door.

Now gathering information no longer takes much effort. We are deluged by floods of data—not only the details of prices, volumes, margins, and capital investments of individual companies, but also highly granular data about credit card receipts, numbers of cars in parking lots, or words used in media reports. These new, “alternative” sources of information have briefly given some stock pickers a slight edge in predicting short-term stock price movements. The informational advantage provided by such data is but fleeting, however; once this data is commercially accessible to everyone, the advantage disappears. Thus, even for the short-term investor, information gathering itself no longer provides a lasting edge.

For long-term investors, the relationship to information has changed even more fundamentally. You no longer need to seek information; it finds you. Your job, rather, is to act as what Lou Gerstner, the former CEO of IBM, called an “intelligent filter”—determining the information that is important and ignoring data that (in the case of the investor) doesn’t help you forecast cash flows and estimate the value of a security.

The fact that filtering information is the long-term investor’s task, of course, doesn’t prevent most from feverishly pursuing every bit of information they can about the companies they follow. Egged on by the 24/7 news cycle, internet chat rooms, and by data providers to know their companies in as much depth as possible, investors often seek to become experts in every aspect of each company’s business. It’s dubious whether this helps them make better estimates of what a company’s shares are worth. Instead, the evidence suggests that, beyond a certain amount, each extra piece of information has zero marginal impact on forecast accuracy. The impact remains positive, however, on the investor’s confidence in their forecast.

The evidence suggests that, beyond a certain amount, each extra piece of information has zero marginal impact on forecast accuracy. The impact remains positive, however, on the investor’s confidence in their forecast.

In one unpublished study, described in Winning Decisions by J. Edward Russo and Paul J. H. Schoemaker, people who handicap horse races were asked to predict, based on increasing amounts of information, which horse would win a race. They found that, beyond a very limited amount of data, forecast accuracy did not improve with more data, but the handicappers’ confidence in their forecasts continued to grow with each extra bit of information.

Knowing more makes you feel better, in other words, but doesn’t help your decision-making. In investing, feelings and actual results arguably are even more disconnected. After all, feeling good about a decision is rarely a help in successful investing—to have a good outcome, an investment view must be different from that of most other investors, and standing apart from the herd almost always leads to discomfort.

Sitting on Our Asses

The job of an investment analyst, then, when forecasting a company’s business prospects and the price that should be paid for its stock is to distinguish between what is important—the signal—and what is useless noise. That’s what we do at Harding Loevner. Our “common language” is designed to guide investment collaboration by helping us focus on low-frequency signals that are important to a long-term investment thesis and avoid being distracted by torrents of high-frequency information that obscure the relevant underlying issues.

We recognize that our industry has an extensive tradition of emphasizing high-frequency signals to induce transacting. In the past, much of the revenue associated with financial services was transaction-based. Brokers were paid only when customers transacted (indeed, when I started my career, so were investment managers!). Unsurprisingly, brokers devoted great effort to stimulating customers to act. Customers responded as you’d expect them to—humans like action, not sitting still. Although the investment management industry has shifted in recent years to replace commissions with asset-based fees, there remains a popular expectation that a good investor will be active, including taking advantage of the most readily available and highest-frequency bits of information: stock price movements (both up and down).

Few investors, though, are able to capture any benefit from high-frequency signals. Our analysts don’t even look at stock prices until a company has been thoroughly researched and qualified as meeting our quality and growth criteria, its long-term cash flows have been forecast, and the fair value of its shares estimated.

Stock prices are much more volatile than the underlying qualities of the business they are supposed to reflect. Investors should remember the words of Charlie Munger, who said successful investing is a matter of “finding a few great companies, then you can sit on your ass.”¹ Of course, while we spend a lot of time following Mr. Munger’s advice, that doesn’t mean we are sitting still. We are constantly questioning our assumptions, testing our hypotheses, updating our information and, occasionally, as a result, changing our minds. Usually, though, ignoring the calls of those whose business model, if not entire worldview, revolves around urging you to move is the key to success.

Compounding the Effect

An investment process structured around the long term, and asking questions about long-term strategy not short-term results, will focus on a few fundamental signals that show a company’s progress in creating value for its shareholders. It will focus on competitive structure of an industry, and durable competitive advantages, rather than on the outcomes of the recent past. It will take what you’ve learned and use that to forecast a company’s investments in its business and the cash flows those investments should generate over long periods of time. Only then can you make an informed guess as to what a company is worth and compare it to what the market is inviting you to pay.

A process focused on the long term also recognizes the importance of compounding—that over a long holding period, even if you did overpay, the rate at which a company continually reinvests its cash flows will be a much more important contributor to your return. In an era when information is so democratized, our one true edge is an ability to latch onto a few incremental competitive advantages that we’ve identified in a company, and allow the company to do its job over the long term and provide the power of compounding to our clients’ portfolios.

In an era when information is so democratized, our one true edge is an ability to latch onto a few incremental competitive advantages that we’ve identified in a company, and allow the company to do its job over the long term and provide the power of compounding to our clients’ portfolios.

Humans invariably underestimate this phenomenon. Compound interest is one of the wonders of the world, yet few people understand how powerful it is. It appears our brains are designed to deal with linear, not exponential progressions.

If there was any doubt about our difficulty in intuiting the power of exponential growth rates, look at how unperturbed most people were a year or so ago when COVID-19 began spreading, first in tiny increments. People could not grasp what the impact of a very standard exponential growth curve could be until it was sloping nearly vertically upwards.

A long investment time-horizon also benefits from the long term being more predictable, despite being the sum of a series of short-terms. When some luck is involved, individual outcomes are unpredictable, but the rules of probability dominate as the number of independent trials and outcomes increase. The outcome of a single spin of a roulette wheel, a roll of dice, or draw of a card is unpredictable, but in the long run the house’s victory is as near a certainty as we can get in this world.

Our job is to turn the coins we toss into unevenly weighted ones, by being disciplined about the information we use, diligent in our research, and allowing the companies in which we invest our clients’ capital to do the heavy lifting for us.