How Can Investors Navigate China Stocks After the Regulatory Crackdown?

China’s fast-paced economic growth is a boon to investors, but recent regulation on China stocks listed on U.S. exchanges may have some investors running for the exits.

In particular, there’s scrutiny on leading technology companies, which has affected investors via falling stock prices and botched initial public offerings.

But savvy investors shouldn’t flee in fear. If you’re interested in adding these big Chinese companies to your portfolio, it makes sense to understand how to manage the risks associated with these regulatory developments. Here’s what you need to know about Chinese financial technology stocks amid the regulatory developments:

— China’s regulatory crackdown: What is happening?

— How Chinese stocks have been impacted by regulatory developments.

— How should investors approach Chinese stocks after the regulatory crackdowns?

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China’s Regulatory Crackdown: What Is Happening?

China’s tech sector has been facing intense regulatory scrutiny recently. Many of the country’s leading tech companies, including Alibaba Group Holding Ltd. (ticker: BABA), Tencent Holdings Ltd. and JD.com Inc. ( JD), have been subject to antitrust investigations.

The State Administration for Market Regulation, or SAMR, a Chinese regulatory authority responsible for supervising market competition, fined e-commerce giant Alibaba $2.8 billion for alleged anti-competitive practices in April. The investigation determined that Alibaba had used its position as an e-commerce powerhouse to put obligations on merchants to sell exclusively on its platform.

While China eyed threats of monopoly power emanating from Alibaba, its anti-competitive concerns grew. The antitrust investigation went beyond Alibaba and reviewed other Chinese e-commerce companies, including Tencent, JD.com, Baidu Inc. ( BIDU) and many others.

In April, the Chinese government settled new fintech regulations for the online sector, ultimately hurting the value of Chinese fintech companies.

In July, Didi Global Inc. ( DIDI), a ride-hailing app, became public. The day after the initial public offering, cybersecurity regulators announced a review of Didi’s data privacy policies, and investors started to become concerned about investing in Chinese stocks. Didi responded by saying it received mixed messages about going public. As a result, the app was pulled out of app stores and the stock plummeted 20%.

With market uncertainty plaguing the sector, the rest of the Chinese internet stocks fell along with Didi during the end of July.

More broadly, China’s response is about a larger backlash to fintech companies and their potential for immense power. This industry is growing so fast that it is difficult for countries to keep up with regulation, which is why investors are seeing more control of Chinese companies.

Brendan Ahern, chief investment officer of KraneShares, an investment firm offering China-focused exchange-traded funds to investors, says Chinese e-commerce companies today make up 30% of all retail sales. China’s policymakers view these companies as critical to the domestic consumption economy, and for that reason, they see a need for some supervision.

These companies are important to the Chinese economy and can even perform some of the functions that banks do. But without proper regulatory supervision, questions about user data and privacy practices arose among Chinese authorities.

[Read: Economies of Scale: 3 Industries That Benefit the Most.]

How Chinese Stocks Have Been Impacted by Regulatory Developments

In general, volatile asset price movements inspired by regulatory news are weighing on stock market sentiment.

“Markets and investors hate uncertainty,” Ahern says. It’s difficult to know what the next move is and when this regulatory scrutiny on Chinese companies is going to end. This has put pressure on the price of the stocks. For there to be some easing in this segment, there needs to be more clarity around expectations on regulations.

As a result of the antitrust investigation, Alibaba had to pay billions of dollars in fines, impacting its stock price, which is down about 16% year to date.

Like Alibaba, Chinese food-delivery platform Meituan was also the subject of SAMR’s antitrust probe and may face a $1 billion fine under the anti-monopoly campaign.

Didi had a controversial IPO in the U.S. in June. The company eventually decided to go public while being advised by China to hold off. Following Didi’s IPO, the Cyberspace Administration of China, a Chinese technology regulatory authority, announced that Didi had violated data laws. The Didi app was removed from app stores in China, and the stock fell 20% that day.

“The entire Chinese fintech sector lost 30% of its value,” says Kevin Carter, chief investment officer of the Emerging Markets Internet and E-commerce ETF ( EMQQ). “It’s growing again, and it will gain that value back, I think, but it’s going to take a while.”

Investors may think that because the stock prices went on dramatic swings, there should be some concern. But from a fundamentals standpoint, the companies have not been hurt, experts say. “What’s driving the stocks down is the sentiment, as opposed to the fundamentals,” Ahern says.

Ahern says Chinese fintech companies have strong cash flows, income and revenue, so there is little to no concern about the companies’ ability to remain competitive. They should not be seen as having issues meeting their debt obligations.

“Because the fundamentals of the companies remain strong, they’ve been able to adhere and adapt to the regulation without an impact on the balance sheets,” Ahern says.

Among those fundamentals is a growing customer base. “As many China concept stocks will be fluctuating in the following weeks, due to the earnings season, among other factors, there is one thing that is not likely to change: demand for goods and services provided by these companies,” says Ivan Platonov, research manager of EqualOcean, a China-focused investment research firm based in Beijing. “Most of the U.S.-listed Chinese firms are leading their segments domestically, with best-in-class talents and capabilities. This fundamental value is likely to bring the public capital back soon.”

Over time, experts say, the Chinese are going to continue enforcing regulations. This regulatory uptick will not only come out of China, but will also be followed by other countries.

[See: 8 S&P 500 Stocks to Buy With the Most Upside.]

How Should Investors Approach Chinese Stocks After the Regulatory Crackdowns?

Investors may wonder whether they should step away from Chinese stocks or add to their positions during this regulatory crackdown. A rational approach market participants can take with Chinese stock investments is to manage their regulatory risk.

To mitigate regulatory risk, experts say, investors should think about how these Chinese companies can protect themselves against additional regulation in their industry.

Kevin Worner, CEO and founding member of ChineseAlpha, an equity research firm based in Shanghai, says those who are invested in the Chinese market or interested in China stocks should be looking to hold companies that abide by strict antitrust and data protection laws.

“These companies should have less than 50% of the market share for their respective industry and should be investing in increasing data security for their Chinese user base,” he says.

You can also invest in companies that have strong data protection and regulatory capabilities, Worner adds.

“These companies will likely be mid- to large-cap companies that have the resources to invest in data security and protection alongside having partners that have regulatory experience, which can advise the firm to navigate the evolving political environment,” Worner says.

Furthermore, if you want to mitigate antitrust risk, Worner says, you can invest in alternative companies that may not stand out as leaders in their respective industries.

Investors may want to be conscious about how they diversify with Chinese equities and make sure they don’t have an outsize position in any particular name. That’s why Ahern says incrementally buying in over time or dollar-cost averaging in China stocks may be a good strategy. “You never want a position to be so large that it could have a correction that you’re not able to top off that position,” Ahern says.

While the regulation has generated some investor concerns, there are still massive inflows in Chinese companies.

Foreign direct investment flows into Chinese investments reached $98 billion in the first quarter of 2021, about three times the inflows during the same time in 2020, with China’s total direct investment inflows on the path of reaching new all-time highs this year, according to data from the Peterson Institute for International Economics.

Carter says now is the time for investors to add to their positions on Chinese stocks. “You buy fear and sell greed,” he says.

Global investors are piling into Chinese investments as the tech sector continues to develop and accelerate the country’s economic expansion. This setup has created a market where investors see new growth opportunities. For example, EMQQ’s allocation toward China is slightly more than 60% in a portfolio highlighting growth in internet and e-commerce activities in emerging markets.

“The best way to invest in the growth of China is the internet companies,” Carter says.

China has a big weight in the emerging markets index, and its e-commerce market is huge. In particular, Chinese internet stocks and tech companies are where value is created and where the growth is. Investors should keep in mind, however, that the risk of regulation is very real.

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How Can Investors Navigate China Stocks After the Regulatory Crackdown? originally appeared on usnews.com

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