Global Emerging Markets Equity Fund comments on China Education Group

Key education companies discussed in this note:

China Education Group Holdings Ltd (1,3% holding in portfolio)
China Education Group Holdings Ltd is an investment holding company principally engaged in the provision of private higher education services. The Company operates its business through three segments: the Higher Education segment, the Vocational Education segment, and the Global Education segment. The Company operates higher education and vocational education institutions in the People's Republic of China (the PRC) and provides education services in Australia and the United Kingdom (UK). (Source: Refinitiv)

TAL Education Group (Not held)
TAL Education Group is a holding company for a group of companies engaged in provision of after-school tutoring programs for primary and secondary school students in the People's Republic of China (the PRC). The Company mainly offers tutoring services to kindergarten through twelfth grade (K-12) students covering core academic subjects, including among others, mathematics, physics, chemistry, biology, history, geography, political science, English and Chinese. It also provides consulting services for overseas studies and preparation courses for major standardized tests, and operates several online community platforms including www.jzb.com (together with the Jiazhang Bang application (app)) and www.mmbang.com (together with the Mama Bang app). The Company’s main brands are Xueersi, Mobby, Firstleap, Izhikang and Shunshun Liuxue. The Company mainly operates its businesses in Mainland China and Hong Kong. (Source: Refinitiv)

New Oriental Education & Technology Group Inc (Not held)
New Oriental Education & Technology Group Inc is a China-based company principally engaged in the provision of educational programs, services and products. The Company provides educational services under its New Oriental brand. The Company operates its businesses through seven segments, including K-12 AST, test preparation and other courses (formerly known as language training and test preparation courses), primary and secondary school education, online education, content development and distribution, overseas study consulting services, pre-school education and study tour. The Company delivers education to its students in traditional classroom settings, in a combination of online and offline classroom setting with dual teacher model, and through pure-play online platforms. (Source: Refinitiv)

Discussion and comments by NS Partners Ltd:
China Education is affected by the increased regulatory risk premium the market is panicking about but in both our opinion and the company’s it is not directly impacted by the latest regulations. It does not conduct After School Tutoring (AST) nor does it educate K-12 or below (compulsory education.). Its focus is on higher education and vocational training – both of which are areas the Government wants more capital and investment into.
 
China Education is still down (as are most investments subject to China regulatory risk) but a comparison vs TAL and New Oriental (which we have always been concerned about) is striking:
• China Education (we own 1.3% in the portfolio) returned -9.0% YTD
• The popular names like TAL Education and New Oriental Education (EDU) are down -92.3% and -88% respectively YTD (which we don’t own).

The situation remains quite fast moving. As can be seen from the recent actions in the US, the Chinese authorities have sought to clarify that the regulatory clampdown is specific to the Education sector. We have nevertheless seen the prior regulatory clampdown in internet names roll into different sub-sectors of the market.

In most cases it’s hard to argue that the regulators do not have a valid case, even if you do not agree with the manner of the execution. To be on the safe side we would prefer to invest where Beijing still wants and needs capital to be invested with companies that are meeting a need and generating as few social costs as possible.

Let’s address some of the key questions that clients have been concerned about. We liked the Education sector and specifically the stock in the portfolio (China Education Group) but never liked the other stocks.

Can you confirm whether you had any exposure to the education companies affected by the recent announcements? 
We have no after-school tutoring (AST) or K-12 education stocks (that teach compulsory age subjects) which are the companies that will now be forced to forego their profit motive – calling into question their existence as listed companies. We do have 1.3% in the higher education and vocational training company, China Education Group which we believe is unaffected by any regulatory changes, though the risk premium of all regulated Chinese investments has ratcheted up.

How are you responding to the situation?
We have checked with the company (one of the founders is ex Ministry of Education) and many analysts and we believe the case is sound, with the aforementioned proviso of a higher risk premium.
The stock we own is down 17.7% YTD after the 21% fall in the last five days (-8.2% over 1 year), which compares to the 76% fall in TAL Education over the last five days, -93.9% YTD and -94% over the past one year. The market is perhaps indicating a bounce in the ADRs. New Oriental (EDU) is doing only slightly better. We own neither of these two.

How were you thinking about these risks prior to the announcement?
We had identified these risks and have never owned TAL or EDU. We are also underweight China, though we are starting to address whether this could be an opportunity to add. Below is a chart on the Education names – we own China Education, in green, which had a poor quarter but the market is clearly telling you something vs the other two which we do not own:

 
Source: Refinitiv

Education stocks are certainly not all the same! TAL & New Oriental Education’s business models have been challenged to such an extent that it is questionable whether they should still be listed. China Education on the other hand has a business that obeyed the spirit and letter of government rules – social positives as well as financial.

Finally, what about your thoughts regarding Variable Interest Entities (VIE’s)?
We still have concerns about VIE structures. We are underweight Tencent, but overweight Alibaba; we are zero-weighted Meituan but have some Dada Nexus (we believe the regulatory clampdown is being extended to include gig economy workers). With hindsight we should have been bolder and been zero weighted Tencent and avoided stocks that might be hit by association but there is some true value appearing in many of these companies which have excellent business models and true cash generating ability through providing genuine value adding goods and services to meet genuine needs.