There has been a recent step-up in regulation in China which has resulted in a sell-off in Chinese stocks, says Alastair Reynolds (pictured below), portfolio manager on the Martin Currie Global Emerging Markets Strategy.

Naturally this has caused some concern for investors and uncertainty about the future investment landscape. However, China is home to some of the world's most promising companies and that some of the common arguments for excluding China do not hold merit under scrutiny.

The new economy companies that are attracting regulatory attention today have, on the whole, been of great service to Chinese society. Their investment and innovation are world-leading and have expanded choice, enhanced convenience in transactions, improved access to information, lowered the cost of consumption and delivered a wide range of entertainment to society.

Based on the volume of regulations being drafted in China and frequent references in state media outlets to the challenges presented by online business models, we believe that the Chinese Communist Party (CCP) has increased the priority of business regulation as a mechanism to reduce inequality and counter abuses of market power.

In the long run, a step-up in regulation should foster more sustainable business practice at an industry level. For the most responsible operators in an industry, regulation is likely to improve their competitive advantage and hasten the exit of unscrupulous players.

The Chinese market sell-off and what it means investments in this space

On a best-case scenario, regulation is likely to alter the rules of engagement for online businesses by setting boundaries where they previously did not exist. Newly created boundaries will be accompanied by newly created penalties in the event of a breach. Accordingly, the role of compliance will become a more deliberate activity within companies.

This will force a reprioritisation of strategy within each of the impacted industries and as existing practices are audited it will slow business progress in the next twelve months.

All businesses will have to digest this phase before it becomes evident whose competitive positioning has been altered. That means investor uncertainty before the winners are announced and will likely be a key driver for the negative market response.

The sell-off has been concentrated in certain sectors and within these, consumer services, retailing and media/entertainment have been the hardest hit. It is very specific to those companies which are impacted by regulation and is not a broad sell-off across all companies.

So why not step aside and wait for the dust to settle?

China contains many fantastic companies - world beaters, with many years of growth ahead and trading on compelling valuations. These companies have delivered enormous value to consumers and investors and we do not anticipate that changing simply because of additional regulation of the industry.

Excluding Chinese companies altogether may put you at risk of missing any upside as the market normalises with companies adjusting to the new regulations. Some of the common arguments for excluding China do not hold merit under scrutiny, such as investor worries that the companies have stagnated growth, the equity markets are overvalued, the potential risk of delisting from the US.

Addressing these concerns: Chinese companies have strong growth prospects and these may be missed if looking through a high-level macro lens only. Furthermore, the Chinese equity markets are actually undervalued relative to the US, in fact the US is at its highest relative premium in 20 years.

And finally, most Chinese stocks are not Variable Interest Entities and are not listed as ADRs in the US. Some of the US-listed Chinese stocks already have dual listings in Hong Kong, which alone has more than three times the market cap of the US listings. Forming an opinion on the entirety of the Chinese equity market based solely on the US-listed portion would be a narrow view.

The ESG story - is China leading global carbon emissions and should it be avoided on ESG grounds?

China was the largest contributor to carbon emissions on an absolute basis in 2019, it is also the world's most populous nation. The largest contributors on a per capita basis are the US and Europe. China is also home to some world-leading companies with positive environmental impacts. China has also made a commitment to achieve net zero emissions by 2060. Moreover, the technology and innovation in China is not only part of global supply chains but it also incorporates technologies directly impacting the environment. China is the leader in electric vehicle (EV) development and this global leadership challenges the negative view of China in relation to environmental concerns.

We are finding exciting opportunities in China (CATL, Wuxi Lead, Minth) and in Korea (LG Chem, Samsung SDI) particularly. The world's largest battery manufacturer, for example, is Chinese. We aim to carry out our company research while taking account of the whole picture and global context, which leads to a portfolio of best-in-class global companies that speak loudly about China's exciting, ESG-leading opportunities.

Look beneath the headlines

While it is appropriate for active investors to be aware of broader changes currently playing out in China, it should not come at the expense of a one-size-fits-all divestment approach. Looking beneath the headline stories, and doing proper due diligence on individual companies and sectors, can present investors with some very attractive long term sustainable investment opportunities.

By Alastair Reynolds, portfolio manager on the Martin Currie Global Emerging Markets Strategy.