As you know I am a big fan of the team at Polen having invested at the Australian inception of the Polen Capital Global Growth Fund. When the Chinese government articulated its love-hate relationship with the computer gaming industry and announced a crackdown on kids gaming it came as some relief to hear the Polen Capital team had made portfolio changes. Polen’s update follows, and it provides a valuable insight into the team’s processes and philosophy.

The Chinese government released several new regulations for its USD $100 billion after school tutoring industry on 24 July 2021. The new regulations effectively eliminate most of the sector. While new regulation was anticipated, the measures taken are far more extreme than expected. These dictates are essentially a complete shut-down of the for-profit industry with no compensation for existing businesses or stakeholders. The dramatic share price volatility seen, first on rumor and then on the actual release of the new regulations, demonstrate the unexpected and dramatic impact of the regulatory changes.

There are certainly reasons to believe that the regulatory actions in the for-profit education sector might not be extended to other sectors in China. However, the demonstration of willingness to make such dramatic regulatory changes does raise this risk in Polen’s view. In the view from the Polen investment team, there is now significantly more risk in any area of the Chinese economy that might be considered “sensitive” with areas like property services, healthcare, and large cap internet being potential examples.

While the Polen Global Growth strategy does not have exposure to the after school tutoring market, Alibaba and Tencent have long been held in the Global Growth portfolio. Those positions have now been exited.

It can be argued that both companies represent two of the more dominant businesses on offer today. Polen have held these businesses as variable interest entities, as that is the only channel for foreign capital to possess shares in each company. This presented a risk because it meant that China had the capability to usurp these businesses from foreign shareholders, resulting in permanent capital loss. The team gained comfort with this risk using the following judgment:

• China appreciates foreign investment in these businesses because both are congruent with the Party’s stated goals of managing the great-power rivalry with the United States and also transitioning their economy from an export driven economy to a more domestic consumption driven economy.
• Shares in both companies are so widely owned on a global scale that appropriating them could lead to significant political turmoil for China, which would not be congruent with the Party’s goals. Lastly, judgment was that the risk of appropriation was so low, Polen felt that given the dominance and potential investment returns both Alibaba and Tencent were likely to produce, they belonged in the Global Growth portfolio. Risk was also managed through position sizes.

While the government has always had the capability to appropriate businesses from foreign owners, until recently they hadn’t demonstrated the will to do so. This changed recently when the Chinese government demonstrated its will by effectively turning its for-profit education businesses into utilities, requiring them to re-register as non-profit entities. This abrupt and unexpected regulatory change decimated the $100 billion for-profit education industry and left foreign shareholders with material and permanent capital losses.

While a logical argument could be made that these extreme actions won’t bleed over into China’s tech sector, increased regulation and the potential for government directed capital allocation from these businesses could lead to lower-than-expected earnings growth.

Put simply, Polen believe that the potential negative outcomes within the investment case for each business has widened while the positive outcomes have likely narrowed.

To be clear, the team at Polen are not “making a call” on China and, in fact, believe that the risk of such draconian regulation of China’s tech sector is unlikely. That said, given the opportunity set within the Global Growth portfolio, it is prudent to reallocate our client capital into businesses likely to produce similar earnings growth over the next five years with a greater degree of certainty.

As such, Polen liquidated the positions and are reallocating the funds. At the time of sale, holding sizes were around 2.5 per cent.

Alibaba and Tencent are great businesses and could certainly feature one or both of them in the portfolios in the future. Polen Capital do not believe that China is uninvestable. They simply recognise that right now the risks have been elevated and are taking advantage of the global opportunity set to achieve the aim of growing the Global Growth portfolio’s underlying earnings growth at a mid-teens rate while taking less risk.

Polen have used the proceeds to add a new position in ICON plc, a global provider of outsourced development and commercialisation services to the pharmaceutical, biotechnology and medical device industries.

The Polen Capital Global Growth Fund owns shares in ICON plc. This article was prepared 10 August 2021 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade ICON plc you should seek financial advice.