No. 21: Unfair Starting Conditions Creating Long-term Advantages, Chinese Regulatory Blitz and Big Tech
This week has been somewhat of a China week for me – given the news over the last week, and how it has smashed Chinese public company share prices. I find it super interesting how the simple word “China” evokes fear in some of my European and American friends. I can understand, it’s not an easy thought to think that your era of dominance has ended and there is a new rising force that plays the game with different rules and a longer time horizon than your homeland.
Getting my ass kicked at school by Chinese classmates in New Zealand was tough. However, this gave me the understanding that I’m going to get my ass kicked in the future – and therefore the fear of the unknown has been taken out of the equation. In addition, I have been an admirer of Lee Kuan Yew (Singapore, not China – I know) since my early teens, so I never thought of Chinese people as foreign or unknowable. The culture and ethos has always been somewhat understandable and pragmatic to me.
Perhaps all of this has made me (rightly or wrongly) feel less threatened by the recent regulatory blitz coming out of the mainland from several different regulatory bodies.
Unfair Starting Conditions Creating Long-term Advantages
One part of the regulatory blitz is the anti-monopoly crackdown on Tencent music. Tencent had exclusive music distribution deals with large record labels. Chinese regulators, in their attempt to crack down on monopolistic practices, stopped these exclusive deals.
My view is that these measures are good for the overall health of Chinese competition and innovation.
But is it good for Tencent?
Tencent benefitted immensely from this monopoly position, and invested behind that advantage, so much to the point that it now has a scale business and can probably compete without the unfair advantage. I imagine that competitors like Net Ease will find it tough to pay as much for music content as Tencent and still make a profit.
It’s a bit like the old story of Coca Cola supposedly added cocaine to the drink. I don’t know whether this is true or not – but if so, probably gave Coca Cola an unfair advantage over other drinks that had no cocaine. And while this unfair advantage eventually disappeared through regulation, Coca Cola still used the monopoly profits to invest behind production, marketing, and distribution. In other words, it competed with an unfair cocaine advantage in the early days and with scale in its second innings. Both incredibly formidable advantages – and both worked to fend off competition at different stages of the business life cycle.
That’s why the music crackdown doesn’t make me lose sleep over Tencent’s prospects in music going forward. But let’s see how the future ultimately plays out. My bet, however, is on the incumbent.
Chinese Regulatory Blitz and Big Tech
I’ve tried to find a bit more nuance than the regulatory headlines which basically (I’m paraphrasing, of course) shout things like:
“Investors worried about Chinese regulation hurting businesses!”
“Command-and-control Chinese government can change its mind about your business on a day-to-day basis!”
And the classic – which pops up probably once a year or so:
“VIE structures are frauds! Jack Ma and the Chinese government are going to take the money and run!”
I don’t know a lot about the Chinese government or the country, but some podcasts and phone calls with various people have helped me understand a bit more.
As per the overview by Lillian Ma, which I link to in my last post, China has a 5-year plan which it uses to direct the economy. The government doesn’t simply make rules out of thin air. They seem to study what makes sense, figuring out which structural foundations they need to lay to enable quality GDP growth and competitive position in the world. For example, the recent private education crackdown that came “out of thin air” started 2-3 years ago – and sector participants were plenty aware that the government was looking over their shoulder.
What I deduced from my skim of the plan is that China intends to funnel resources towards hard tech (semiconductors, for example) and primary research, along with taking a baseball bat to drivers of inequality in education, housing, and healthcare. To me, this sounds decent – and it’s something that I secretly wish would happen in the west.
A Short Note on Private Education
My Chinese friends tell me that private “cram schools” rake in tens or hundreds of thousands of dollars from insecure parents who want their children to achieve good grades in school. These private schools then reinvest profits into advertising to other insecure parents about how expensive cram schools can likewise benefit their children. Asian parents spend big on education, so they are easy targets for manipulative marketing. It’s not that the quality of private education was necessarily bad, it’s just that only a certain few could afford it for their children - thereby driving inequality if it was allowed to continue as per the status quo.
Public education is a major driver of equality, taking people from all backgrounds and offering them upward mobility and inclusion. If private education absorbs the best talent, students, and resources, and benefits only those who can pay through the nose, poor people are left with a lower quality of education and future opportunities – thus widening the inequality gap.
Another factor is population decline. If ordinary parents believe they must put aside a fortune for their child’s private education then they might choose not to have children in the first place. Therefore, it has become a national priority to dismantle private education in its current form – and we see companies like TAL Education losing market value overnight because of the regulation requiring private education companies to become non-profit.
Again, tough love from the Chinese government - but I still see this as a good thing.
Big Tech
I don’t know exactly what the effects of regulation on Big Tech might be. All I know is that it is complicated because the Big Tech companies contribute a lot to China’s overarching goals – but there are some characteristics of them that potentially stifle innovation or are harmful to society. It’s a mixed bag, at first glance.
Certain regulators seem intent upon reigning in a shadow banking system. This is not new news, and we have seen several attempts to reign it in over the last 10 years. Cowboy companies break loose and offer loans from their own capital, potentially charging inadequate (or usurious) interest rates, improperly handicapping financial risk, and therefore destabilizing the financial system at large. Though regulation may damage the short-run numbers of Big Tech lenders, I think it is the right step for the government to take – and will probably make the space more investible in the long run. And though regulation is sometimes a pain, and not all of it is sensible, I think we can say that the US banking system is safer because of regulation rather than despite it.
There are some regulations coming under the banner “Data Security” which doesn’t tell me much. But what I can understand from this podcast is that China is figuring out how to treat data as an asset class. They are asking questions like: “Should the Big Tech companies own the data they mine from users?”, “Should Big Tech be allowed to track people at an individual level?”, “Should data instead be a shared, common resource which we can release to other companies to innovate on?”. And while this may result in companies like Tencent and Alibaba losing proprietary access to aspects of their data, it doesn’t mean that their incumbent advantage goes away. Sure – you can have two people in their garage starting the next Tencent or Google, but Tencent still has high quality of talent, resources, and reach into various industries that gives it advantages over most individuals to utilize data even if it ends up in the public domain. Maybe this should scare me more than it does - and if anyone can shed some light on the topic, I’m happy to learn more. My bet, however, is still on the incumbents, in the absence of further information.
Then there is the recent crackdown on gaming – in the headlines yesterday. It’s clear that Tencent will have to play an active part in tackling youth gaming. This has come up before in 2018 and looks like a persistent issue for Tencent. Limiting the number of hours played by youth users seems to be the way forward – however in reality I imagine that this is hard to police because youth gamers have always been great at finding creative work arounds (I was one of them – but not a very good one). On the other hand, Chinese gaming domination is growing, and its profile as a sport is also growing. Would China want to significantly handicap its best bet (Tencent) in a field where they have global dominance? I’m not so sure - given gaming’s rapid growth as an official sport.
My final point is that dominance in semiconductors and other hard tech (part of the next 5-year plan) depend to some extent upon having a solid end-market ecosystem within which to develop new products and use cases. Companies like Tencent, Alibaba and ByteDance are end users of CPUs, GPUs and other such semiconductor products (I heard that ByteDance alone buys 50% of all NVIDIA GPU production every year!). Having strong local champions gives local Chinese hardware developers a chance to have guaranteed big buyers of semiconductor products. So, even if the world turns its back to Chinese hardware manufacturers, the local Big Tech players can step up and provide some stability to the hard tech ecosystem that the Chinese government aims to cultivate. In my mind it makes little sense to handicap your national champions who can support many other sectors either directly or implicitly.
VIE Structures
According to this great Twitter Spaces recording by Value Hive, China is capital starved. It doesn’t have enough internal capital to fund its growth, and therefore might like to remain open to capital markets. Even though VIEs do not give foreign investors enforceable claims over Chinese assets, would it necessarily make sense for Chinese stakeholders to take the cash and run? Aside from pissing off global investors in Tencent, Alibaba, and others, it would totally detonate trust in China’s financial markets – which puts at risk future flows of foreign cash to fund China’s growth. So, while it is probably a risk in some sense, I think I’m not afraid of the VIE structures being a total pump and dump fraud.
Overall
It’s moments like these where the boundary between stupidity and intelligence might be really thin. And some very intelligent people I respect are selling Chinese Big Tech stocks as we speak – which makes me either insane or somewhat balanced for suggesting that the situation is safer than they think it is. I understand the second derivative of the recent regulatory storm - which is that if the CCP is stepping deep into business today, what stops them from going deeper tomorrow? I think it’s a valid point, however I also just see too many pragmatic, self-interested points for the Chinese people to keep Big Tech alive and profitable. It is literally in no one’s interest to kill or weaken them - but I do agree that the occasional clip of the wings keeps all parties in line. Let’s see how this all plays out (Disclosure: Long Tencent and Alibaba - but I can change my mind at any time)