In this video, Industry Focus host Jason Moser chats with Kai Zhang, a senior analyst at Esoterica Capital. Tune in as they talk about the current regulatory environment in China, how investors should view opportunities in the region, and much more!
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This video was recorded on Sept. 15, 2021.
Jason Moser: It's Wednesday, Sept. 15th, I'm your host Jason Moser and on today's Wildcard Wednesday show, we're digging into the current investing landscape in China with a special guest. Kai Zhang is a senior analyst with Esoterica Capital, an asset management firm based in New York City, New York, focused on investing in the digital economy. Formerly with Goldman Sachs, Kai is an expert on Chinese regulation, public policy, the tech landscape, and geopolitics. Kai is also pursuing a concurrent degree of Master of Business Administration at the Wharton School, and Master in Public Administration at the Harvard Kennedy School of Government. Recently, I had the opportunity to chat with Kai about the current regulatory environment in China, how investors should view opportunities in the region, and much more. I hope you enjoy our conversation. Kai, thanks so much for joining us today. There are a lot of questions I want to ask. But really, let's just get right down to the question everyone has right now, all investors have right now, and that's regarding the state of publicly traded companies in China. I mean, there has been a lot of, volatility is probably the best word. I mean, a lot of headlines, certainly, it seems like every day something different is happening, and it seems like the Chinese government has certain goals that they're trying to reach. But it's all still a little bit unclear, I think for your typical American investor here these days. Give us your take on the state of publicly traded companies right now in China. Tell us what exactly is going on.
Kai Zhang: Thank you for the question, Jason. To answer your question, I want to quote one number, that is 1 trillion U.S. dollars. Now, what that means, it means the total market cap of the publicly traded Chinese companies and the Hong Kong Stock Exchange and also the Chinese ADRs. That's how much market cap evaporated since the Chinese government launched its series of regulatory, we call it a reset. Now, why is that? The government now is trying to reorient its policy to balance to the next stage of growth, and of course, with those many routes or overhauls, there are casualties, there are turmoils for the short term. But if you look from the big picture, the government is really focused on a few fronts. The first one is anti-monopoly or antitrust. There is also to ensure the common prosperity, which is more about economic equality, and then there is also other fronts on environmental protection and whatnot. Just to give you a big-picture view of what's going on in China.
Jason Moser: Right. I mean, understanding there are a few different priorities there, one of the priorities I've read about and you can correct me if I'm wrong here, it seems like one of the top priorities is trying to narrow the wealth gap. I mean, you mentioned creating more equality in the wealth spectrum. Narrowing that gap as far as income inequality. Does that feel like the top priority to you, or is this just a combination of a lot of different things?
Kai Zhang: I think it's a ladder, Jason. I think the Chinese government is dealing with many issues at the same time. It is a new stage in China's development. Remember that only 40 years ago, China was still a very poor, very rudimentary economy. Now, I think some people are getting a lot of benefits from the economic development, but more are locked behind it. Actually, I want to argue that most are locked behind. I think before President Xi Jinping, he came into power, China's Gini coefficient was a lot higher than many of the developed markets. Actually, I think it's one of the highest among all of the world major economies. Among many things, I think the Chinese government is really trying to tackle the problem of economic inequality to sustain the long-term growth of China.
Jason Moser: Do you think that what they're doing is the right way to go about it? I mean, do you feel like this is the most sensible way to try to address the problems that they want to address? Or do you feel like there are perhaps could be a different or a better way?
Kai Zhang: Absolutely. I think it depends on which perspective you have, how you look at the whole overhaul. There are two parts of any policy. One is the policy design and then the other half is on execution. I want to argue that the ideals behind China's regulatory rehaul, I think it has very benign intentions. Now, in terms of execution, I think no execution is perfect, especially on messy topics like income inequality. Here, I think, China is having good intentions getting to this, but at the same time, I think the execution, they're not doing it in a perfect way. Which is understandable.
Jason Moser: Yeah. I mean, I think that's probably virtually every government around the world. This is probably guilty that at some point, not executing it perfectly. Not executing it to the extent that probably the majority of the people would love to see. But with that in mind, I was looking at a chart earlier today and just comparing some of the more well-known names in Chinese investment opportunities, a lot of the names that we hear in our universe here at The Motley Fool, I'm sure a lot of the names that you're familiar with too, JD.com and Alibaba, Baidu and even Sea Limited. It was interesting for me to see that year to date, where the S&P has had a pretty good year so far, we're looking at around 20% returns with the S&P this year. You've got JD.com, you've got Baidu, and you've got Alibaba all, not only trailing the market, but in negative returns. That's just year to date, and obviously, we take a much longer point of view which I know you do too at Esoterica.
Kai Zhang: We do.
Jason Moser: But one exception there is Sea Limited. Sea Limited is having a really good year up better than 70%. What do you think? What's the disparity there? Why is Sea Limited seemingly exempt from this volatility?
Kai Zhang: Absolutely. Sea Limited, I think it has a slightly different exposure than all of the Chinese names you mentioned. Sea Limited, actually, it's a Singaporean company and its main market is in actually Southeast Asia. The economy there is growing maybe in a different stage, but on par in terms of growth rate with China. Then in those markets, you do not have the regulatory overhang as you do in China. What we're seeing is that investors are still hungry for growth. They are finding this very stressful. You all know how difficult it is to find a really high-quality growth in our world.
Jason Moser: Yeah.
Kai Zhang: Exactly. Then what happened is a lot of the investors in those Chinese equities you mentioned JD.com and Alibaba, they're trying to actually transfer their exposure into Sea Limited. It's a substitution of the many high-quality Chinese names you just mentioned, because of this regulatory overhang.
Jason Moser: When you see those names, those businesses like Alibaba and JD.com and Baidu, when you see those businesses underperforming in the near term like we're seeing, and we know why, we generally speaking know why, I mean, that's what we're talking about today. Do you view that personally or as at Esoterica as a team there, do you view that as concerning or do you look at that as an opportunity for investors who are willing to take the longer view?
Kai Zhang: Absolutely. I think it depends. Esoterica, we're very bullish on the long-term prospect of China. We do certainly understand there are the short-term concerns from investors, especially on the regulatory side. Our suggestion is, for investors who follow China closely and who are comfortable with those risks, we think now is a great time to increase your exposure in China. But then at the same time, if you're not comfortable, maybe the right way to invest in China, is to delegate to some experts who know that area well. That being said, I think that for the long term, we're still very bullish on the long-term prospects of China.
Jason Moser: Yeah, and I want to go back to this Sea Limited for a second. Because I understand it's a Singaporean-based company and I mean, I wasn't trying to lump Sea Limited in with other Chinese companies, but I think generally speaking, on the whole, investors tend to look at this from a very big-picture perspective and say, oh, well, investing in that part of the world is too challenging. There are things going on in one government that may bleed out into other nations that could be a problem for that general region. So I guess I wonder ultimately is, when you look at a company like Sea and you see what's going on in China regarding the regulatory shifts that we're seeing. Are there any other companies in the general region? Not necessarily Chinese. I mean, they could be Singaporean-based, they could be anywhere else. Are there companies that you feel like, are you familiar with that phrase that we use the throwing the baby out with the bathwater?
Kai Zhang: Yes, absolutely.
Jason Moser: Are there any companies out there you feel like these are these are babies that are being thrown out with the bathwater? Maybe investors are missing the real, the bigger picture there?
Kai Zhang: Absolutely. So in the case of China, absolutely. Investors are throwing the baby out with the bathwater [laughs] and that's actually the plan. At the same time, although investors should take differentiated view across the different companies, say, Alibaba versus Tencent, they have very different risk profiles in terms of rivalry. I still think that this overall investor sentiment is significantly impacted by the recent regulatory overhaul in China. Then in terms of Sea Limited, the company, as in Singaporean company, we're seeing that investors are flocking into Sea as a substitution to the Chinese names. I think, actually, it proved that the Chinese model actually works. Because if you look at the Southeast Asian countries, in some ways, they're emulating what China did maybe 10 or 20 years ago in that they're all similar trajectories as China was maybe one or two decades ago. Here is an interesting analogy, Jason, that that maybe you have heard about it, which is Sea is the miniature version of Tencent plus Alibaba in Southeast Asian countries, to that I found it interesting and funny, but I think it's true.
Jason Moser: That is an interesting comparison there. I want to pivot for a second and as an advisor here at The Motley Fool, and run a couple of investing services, one of my jobs, obviously, is to find good businesses and recommend them to our members. I get the question a lot, in regard to Chinese companies and just generally investing in that region, not necessarily just China but companies in that region. I have owned Chinese companies before. Today, though, I tell people I don't invest in China because I simply don't. I recognize for me there's too much that I don't know or in other words, I know what I don't know and I don't feel like I can get a grip, at least to be confident enough to make recommendations, to feel comfortable making those recommendations. Just because I feel like there's so much I don't know. So what do you say to the investor like me? Why should we invest in China? Furthermore, how should we go about doing it?
Kai Zhang: Absolutely. Jason, first of all, let me say that I really appreciate your being disciplined. [laughs]
Jason Moser: Well, it's not always easy. [laughs]
Kai Zhang: We, at Esoterica, we have a tenet, I think, shared by many investors is that investing is essentially to monetize your understanding of the world and if an investor does not follow a market or asset class closely, then the best way maybe is to find better alternatives. So we think that maybe the best option for people who want China exposure, but do not follow the market very closely is to delegate to some experts in that area. But then we believe that China still stands a very important source of growth. We mentioned about this, Jason, in our early conversation that, growth in our world is scarce — difficult to find. Especially that consistent high-quality growth you have been seeing in China for the last two or three decades. Now, how do I get comfortable with China's future? I think it relies on our understanding about where China came from and where is China now and where China will go for the next stage. China is a very interesting country that it does not follow step-by-step, the classic political economic models invented by the Western economists because the country has lots of historical contexts that people from the West, they often tend to overlook. But we're a bunch of Chinese nationals at Esoterica we're U.S. educated and U.S. trained at some of the good institutions. We believe that we can see China not only through historical perspective, and then also incorporating a lot of elements from our training in the U.S. If you see China where it is now and where it's going for the next decade, we believe that China is doing what it should do — aka reoriented its government and policy machine to fine tune it to suit for the next stage of growth.
Jason Moser: What do you feel like, you got into this just a little bit here a minute ago, but I want to see if we can dig in a little bit more. What are the cultural differences between investing in China versus investing in the U.S.? What are some of the main cultural differences that you feel like U.S. investors should be aware of?
Kai Zhang: Absolutely. It's a great question, Jason. I think the top difference between investing the two markets is to appreciate the role of the Chinese government in the economy. I think that's No. 1 thing that people tend to neglect. Then I think maybe one year ago, two years ago, the trend was not that apparent, although you'll feel the presence of the government in the economy. But with recent regulatory overhaul, you feel it in a more tangible way. On top of that, I also want to add another which is. Let me tell you a secret, Jason, [laughs] that a lot of the American investors often neglect that China is not precisely a system that operates solely on rule of law. Rather, I think the Chinese system operates more on what do we call the rule of principles. Here, the Chinese political system, they believed that the ends justify the means. So there is not a process justice. There is the result justice as long as the government can get its goal and it does not bound itself to the rule of law. So largely speaking, I think the Chinese regulators, they have a very pragmatic view on the status of rule of law in the society.
Jason Moser: That's an interesting point that you make there to me that that indicates, at least to me as an investor, that understanding the role that government plays in the near term, it sounds like it could offer up some unpredictability, some things that would be very difficult to forecast or understand exactly. But taking a longer view, it's about getting to goal down the road and so you might see some bumps along the way. But as long as you understand where that proverbial finish line is and what they're trying to accomplish. It would encourage investors certainly just at least take that longer view focus on investing in companies you feel like that can withstand those bumps along the way. So that makes a lot of sense, particularly when you compare it to investing here in the United States. Obviously a bit more just rules and law focused. I mean, that's the way it's always been. Although I think that certainly has been up in the air recently, too, it feels like for a lot of us. [laughs] When you're looking for opportunities in China, which I know that you do. I remember when I spoke with Bruce here a little while back and we were talking about some of his favorite opportunities in the area. What are some of the traits you feel like investors? This is what do you look for and what do you think other retail investors, what are some of the traits that you feel like investor should look for in finding those opportunities in China. What makes a good opportunity in China stand out to you?
Kai Zhang: Absolutely. Jason, I want to use a buzzword. It sounds cliche. But then bear with me, the word is ESG.
Jason Moser: Oh, yeah. [laughs]
Kai Zhang: Environmental, social, and governance. In the West or capital markets, I think now investors are embracing more and more on the term ESG. But that makes relevant in the Chinese context. I believe that the best Chinese companies at this stage, they will exhibit good track record and good intention and good willingness to comply to the ESG standards. The first one I want to talk about is actually about social. You know how this Chinese regulatory overhaul started in the first place? It was maybe over the last couple of years when a lot of the Chinese internet powerful companies. Those are the main ones, there's all about Alibabas. They first use heavy subsidies to getting to the market. Then once they achieve this monopolistic status, they take price, and then they get profits, which is very, very typical, very rational business behavior. But in the meantime, that hurts a lot of the low-level employees or gig economy workers in the inner process, and so that created a huge backlash in the Chinese society. I would argue you that when these companies were taking price and whatnot, they neglected very crucial aspects on the social front in the ESG. Then that was one inherent risk embedded in their business model. That's just an example. Then of course, now I think most of the Western investors, they should understand the importance of governance. For example, property alignment of interests of the management team, and also the shareholders, and also the prudent allocation of capital and whatnot. That's just a given. It's the same thing in China, too. Then also, another thing I want to mention is on environmental issues. If you look at Xi Jinping, he has a book, he has a volume of speeches and whatnot. He repetitively mentioned one priority policy which is on environmental protection. That is actually also another priorities for China going forward. When Xi took power in the early 2000, 2012 actually he came into power, pollution, air pollution in Beijing, for example, was bad. Now it's much better after almost a decade of improvement. You're also seeing that China is huge in renewable energy space and also EV. These all show that companies that have good compliance or actively take on such opportunities, those would be the ones that I would call exhibit very good traits in China as good investment model targets.
Jason Moser: Well, putting all of this together in given what you and Bruce and the team in Esoterica are doing on a day-to-day basis, I have to ask, are there any particular Chinese companies that have your interest today? What are you and the team focused on? What are couple of businesses that you were really excited about there at Esoterica Capital today?
Kai Zhang: Absolutely. We have a moderate exposure to China and our mandate is really to find the best companies, the best investment ideas globally.
Jason Moser: I like that.
Kai Zhang: Thank you. Good mandate. [laughs] Well, it worked very well for us. In the meantime, well, we tend to take a very opportunistic stance on how to actively allocate our risk exposure. Now, we're focusing very much on the Chinese because we think it's a very attractive sector. Now, in terms of what specific securities we have, one such name on top of your mind is Tencent. Analogical wise, it's the big brother of Sea Limited but it's in China. For people who are not familiar with Tencent, Tencent really the company can be broken into two parts. One is on the social media. There you have the WeChat and the QQ, another instant messaging platform. Those two platforms, especially WeChat, they became ubiquitous in China and they became the foundation of a lot of the technology platforms in China. We can order food on it, you can submit your COVID test results, or a vaccination record on there, whatnot. Then on the other side, Tencent also has a sizable gaming operations. They provide a lot of the mobile games and that's been very profitable. The reason why we like Tencent is because we think it's a company that's very disciplined, exhibit a very good ESG track record and willingness to comply, and then also the valuation is very attractive.
Jason Moser: One more question before I let you go, because you mentioned gaming and this is something that's just come up recently, but I know that it's something that's caught a few eyes. Do you have any concerns with the notion that the Chinese government wants to limit the amount of time that kids can play video games over the course of a week? I mean, it seems like that would be very difficult to implement so I'm not sure exactly how they do that, but I don't know. I mean, how do you feel? To me, it just feels like it would be a very difficult thing to implement. [laughs] It doesn't make me any less bullish on the sector. As a matter of fact, I think it makes me more bullish because they realize how powerful it is. But I also understand the perspective of there's this notion that they could be addicting and that could be problematic for younger children as they grow up into adulthood. Do you have a perspective there on that effort on trying to limit the amount of time spent playing games?
Kai Zhang: Yes. The short answer to your question, Jason, is that I'm not particularly concerned about this limitation on kids at given time. The reason is because if you look at Tencent, only, I want to say 1% of the accounts are registered under the kid's name. That's teenager user name. Of course, the real number maybe it's kids taking parents identification and then do the gaming online, that's probably a bit bigger.
Jason Moser: Yes. [laughs]
Kai Zhang: I want to say that it's much bigger. The proportion of the teenagers as a proportion of the total gamers on Tencent platforms, that's relatively small. I'm not saying that Tencent is not impacted, it is impacted somehow. But then I think if you look at the grand picture, it's adults that spend the most both time and money on those games.
Jason Moser: Interesting.
Kai Zhang: To be honest, I think the Chinese government clearly indicated that they are not only now on to penalize those gaming companies. Actually, they want to enhance the status of the Chinese gaming companies because they see that as an important tool to increase China's soft power. It's just another format of media that is very addictive. They want to limit the kids, not the adults. Excellent question, Jason, about how to implement this regulation. Three hours per week per child, that's very difficult. How do you do that? I don't think they can do it again, 100% just given how complex our world is. But that I think with technology, I think the gaming companies will come up ways to more closely execute the government's mandate. For example, Tencent, they are [unclear]. Maybe they can develop some technologies to verify the gamers by their facial features to see if either that's a minor or that's an adult. I think with technology, the magic of that is they can enable a lot of the previous impossibilities into possible. That's why we love technology at Esoterica.
Jason Moser: Well, Kai Zhang with Esoterica Capital, this has been a wonderful conversation. Thank you so much for taking the time to join us this week on Industry Focus. I look forward to talking again with you very soon.
Kai Zhang: Thank you very much, Jason. My pleasure.
Jason Moser: That'll do it for us this week, folks. You can learn more about Esoterica Capital by visiting their website at Esotericacap.com. You can follow Kai on Twitter, @KaiEsoterica. Remember, you can always reach out to us on Twitter @MFIndustryFocus or drop us an email at email@example.com. [MUSIC] As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Thanks as always to Tim Sparks for putting the show together for us. I'm Jason Moser. Thanks for listening, and we'll see you next week.
Jason Moser has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alibaba Group Holding Ltd., Baidu, JD.com, Sea Limited, and Tencent Holdings. The Motley Fool has a disclosure policy.