Milltrust GEMS Commentary on China

July 28, 2021

BY Milltrust International Group

We are writing to provide you with an update by Xingtai Capital on our China exposure in the Milltrust Global Emerging Markets Fund following the extreme sell-off in Chinese equities triggered by the recent announcement of policy changes from the Chinese government in relation to the after-school tutoring companies within the education sector, and the government’s announcements regarding the property management services sector.

What happened:
The “Double Reduction” policy was published by the government last weekend after much speculation over the past several months. The policy confirmed that after school tutoring (AST) operators are required to be not-for-profit for its K9 compulsory academic related business and are prohibited from operating via a VIE structure. The government also banned all public holiday, weekend and summer courses. Lastly, the government announced that they will not issue any more new AST permits and will ban companies from listing or raising capital for M&A.

We had expected some regulatory change towards the K9 segment, but the outcome of forcing all AST operators to be not-for-profit took the market and us by surprise. In summary, this was the strictest form of the policy.

The policy goal behind this change is to avoid social unrest and ensure social stability. The government wants to provide equitable access to educational resources for all Chinese households. The current popularity of AST services is mainly with the higher income households, creating tensions amongst lower income households that cannot afford these services.

Our exposure and impact:
We do not have any exposure to after school tutoring companies.

Our exposure in the education space is purely to the non K9 higher education companies. The government’s objectives are to migrate from mostly public to more private operators for higher education so our investments are consistent the government’s objective. Although these stocks have suffered as part of the fallout and weak sentiment, we believe there will be limited policy risk to the stocks we own.

The Promoting Private Education Law was officially announced in June 2021, which confirmed that non K9 private education operators are encouraged to be for-profit entities without restrictions on VIE structure and M&A. These laws are usually not revised for the next 10 years. In addition, government investment in the primary and junior high school segment has continued to rise while it has decreased in the high school and higher education segment. Therefore, we believe that to continue to grow the latter, there will be a greater reliance on the private sector. Therefore, development of private higher education and vocational training in China remains consistent with the government’s objectives and also ultimately improves the employment ratio longer term.

On a fundamental perspective, our education names are expected to deliver average 30% earnings growth over next two years with an average P/E of 7x FY21.

Property Management Services
What happened:
A few Central Government Departments issued guidelines mainly aimed at property developers. The guidelines also reminded property management service companies not to over-charge their clients through revenue generated from common areas. This was a reminder and not a change in policy. All our portfolio companies are in compliance with these guidelines. Further, revenue derived from common areas make up an average of 2% of total revenue for the entire sector.

Our exposure and impact:
In our view, we do not consider these reminders to be material news and believe they have no impact on the fundamentals for these companies nor does it change our long-term positive view towards the sector. It is not a new policy and as mentioned, the revenue driver from common areas is minimal. The timing of these announcements happened during a week of significant market volatility. The correction of stocks in the sector was triggered by the overall risk off sentiment, and within this sell-off, recent winners have underperformed.

On a fundamental perspective, our holdings within the sector are expected to deliver average 50% earnings growth over the next 3 years with an average P/E of 17x FY21.

We have seen extreme risk off this week as the whole market has become collateral damage to the negative sentiment arising from these regulatory changes. We have seen sharp corrections before, and in our view, the market will stabilize. With first half earnings season in August, the focus will likely re-focus on fundamentals again.

Categories: News