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New Oriental Education leads rebound of Chinese tech stocks following inclusion in global portfolio

Thiveyen Kathirrasan
Thiveyen Kathirrasan8/26/2021 08:45 PM GMT+08  • 6 min read
New Oriental Education leads rebound of Chinese tech stocks following inclusion in global portfolio
To be sure, this rally took place amid a wider rebound of some very prominent Chinese tech stocks.
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In the previous week’s The Edge Singapore (Issue 998, Aug 23), we wrote about buying Hong-Kong listed Chinese education services provider New Oriental Education & Technology Group for our Top 10 global portfolio. To recap, we bought this stock because it was heavily hit by strict government regulations. As such, the company lost almost 90% of its market capitalisation from its February highs and we saw this as a buying opportunity.

Based on our estimations and reported analyst consensus, the potential impact to earnings is not as dire as the actual drop in price. Hence, this implies that the market likely overreacted to the impact and the stock is trading at a bargain. This is a high-risk stock given its fundamentals are expected to be negatively impacted but we are focused on the potential mispricing of the stock.

Furthermore, this stock was purchased to replace the riskiest stock previously in the portfolio, which was a turnaround stock, and given our portfolio is a balanced mix of stocks with varying risk to reward ratios, this justified the purchase of New Oriental. Portfolio allocation is just as important as stock selection so we replaced the other turnaround stock with a recovery play to keep the portfolio balanced.

The reason behind why we purchased a stock like New Oriental is based on the concept of mispricing. The mispricing implies that the stock’s true or fair value (based on the investor’s analysis and research of the stock) is much higher than its trading price. In this context, when a shock happens or when the company announces results which differ from expectaions, the share price is likely to move based on the news. This usually presents an opportunity for investors to capitalise on, in both the short- and long-term.

For shorter-term investors, the larger the gravity of the shock (or the degree of news that is different from expectations), the higher the likelihood of the market mispricing the stocks due to emotions and lack of time for thorough research.

There are three types of mispricing following a shock. Firstly, if the shock is beneficial to the company, the share price rises. Secondly, if the shock is positive but the share price falls (or vice versa). Thirdly and the riskiest of all is when the shock is negative and the share price plunges.

New Oriental belongs to the third type and if the mispricing is indeed true, the potential returns will be the highest compared to the other types. However, if proven wrong, this will cause the opposite effect.

As Chinese technology stocks rallied for the day, New Oriental did too, gaining 12.8% for the trading day of Aug 25. Post-price surge, this stock is up 7.4% for our Top 10 portfolio just within a week. Our estimations for the fair value of the company after taking into consideration the worst-case regulatory impact indicates that the company has slightly more upside room before it is fairly priced and hence New Oriental will remain in our portfolio.

To be sure, this rally took place amid a wider rebound of some very prominent Chinese tech stocks, which in recent weeks have been hit by one wave of tighter government curbs or regulations after another. Beaten-down names ranging from Tencent Holdings to Alibaba Group Holdings have all bounced back somewhat from Aug 23 onwards as investors bottom-fish following some half a trillion US dollars in market value were eliminated in the preceding fortnight.

From the perspective of leading asset manager DWS, the Chinese economy will see tighter, more active regulatory actions moving forward. As such, investors, especially foreign ones, may be increasingly sceptical. However, DWS believes that following the recent sell-off from two weeks ago, these Chinese stocks were in an oversold situation and “which might suggest it has potential over the medium term”.

At present, the challenge is to decipher where the Chinese government would next turn its sights on, and even within the same industry sector, there might be both “winners” and “losers”. Therefore, “caution seems to be warranted” especially for companies such as large technology, real estate, or education companies and healthcare companies. “In general, companies with market power that translates into pricing power are likely to remain within government’s sights,” notes DWS.

As flagged by Citi Global Wealth Investments’ CIO office, the recent series of Chinese regulatory crackdowns has caused investors to question the efficacy of investing in China. Furthermore, the concern over Chinese equities is not just domestic. “Governments on both sides of the Pacific have expressed displeasure with the current system of Chinese companies listing on US exchanges and we expect many Chinese unicorns will choose to list closer to home going forward. We suggest investor caution in adding exposure to US ADRs, particularly those firms which have yet to achieve profitability and therefore are ineligible to initiate a dual share listing in Hong Kong,” says Citi.

Despite suffering from the selldown, Citi notes that net flows into Chinese equities have remained steady. Data from the Hong Kong-Mainland Stock Connect indicate that much of the recent selling has in fact come from Mainland investors while “northbound flows into A-shares from foreigners have moderated but remained positive in July and August. This presents a risk to markets if foreign buyers lose confidence due to the government’s intervention in public and private businesses. And foreign buyers have not been reassured by recent government statements supporting China’s capital markets.”

If seen within a historical context, the hit on the market now is a buying opportunity. Over the past decade, Chinese shares have experienced two boom-bust periods and both selloffs. The first was in 2015 with the government’s currency adjustment, which followed a period of true euphoria in Chinese equities, preceded by a 43% decline in Chinese equities which persisted through early 2016. Then President Trump’s trade war brought down Chinese shares again in 2018 until a trade deal was reached in 2019 (see Chart 1).

“While we do not believe that Beijing has completed its regulatory roll-out, we see some investors as selling first and asking questions later which may present opportunities for adding to quality Chinese names at a discount to global peers,” says Citi.

Photo: Bloomberg

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