Finance

Wilmington Trust’s Meghan Shue is out with a contrarian playbook designed to help investors grab profits during volatility.
Even as correction forecasts increase and risk appetites slump on Wall Street, she lists overweighting stocks as her first recommendation for those with 9 to 12 month time horizons.

“Over that time frame, the economy is likely to perform at above trend rates — being supported by consumer savings, cap-ex and an inventory rebuild.,” the firm’s head of investment strategy told CNBC’s “Trading Nation” on Friday.  “So, we think stocks are well-positioned to outperform bonds.”
Next, Shue emphasizes buying emerging market stocks. It includes one of the Street’s most unpopular spots right now: China, which is getting hammered by new regulations targeting industries including big tech, crypto, and casinos. Plus, it’s dealing with the fallout of Chinese property developer Evergrande’s debt crisis.
“Risks are certainly elevated in China,” said Shue. “Certainly, property weakness puts some downward pressure on the economy. But we think regulatory risks are at least somewhat priced in at this point. Chinese equities are down 30% since February.”
Third, Shue, who oversees $141 billion in assets, believes investors should overweight cyclicals and temper their enthusiasm for technology stocks. Her top picks are financials, industrials, energy and materials.
“We’re also overweight the international developed equities which have more of a cyclical bend to them and tend to benefit more from a global economic recovery,” said Shue, a CNBC contributor.

Her base case is global re-openings interrupted by the Covid-19 Delta variant surge will resume in the fourth quarter, which kicks off this Friday.
Shue’s fourth play is to broadly overweight commodities on the continued impact of solid demand, inventory rebuilding and inflation.
“That transitory inflation view is pretty much consensus,” Shue said. “While we also think inflation pressures will subside as we move into 2022, we think there’s some upside risk… So, we’re putting this on as a hedge.”
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In years past, early bird shoppers may have turned to layaway plans to reserve holiday gifts and pay for the purchases over time. But retailers, including Walmart, have scaled these options back.
Instead, many retailers have embraced buy now, pay later options offered by companies like Affirm, Afterpay and Klarna.
RBC Capital Markets estimates these point-of-sale loans increase retail conversion rates 20% to 30%, and lift the average ticket size between 30% and 50%.

Supply chains are snarled and manufacturing is constrained. For weeks, headlines have been telegraphing a clear message to shoppers: This holiday season shop early.
In years past, early bird shoppers may have turned to layaway plans to reserve holiday gifts and pay for the purchases over time. But many retailers — including the nation’s largest, Walmart — have done away with or scaled back these programs. One reason is shoppers have new tools at their disposal to spread out payments.

A popular option for consumers are buy now, pay later plans. Retailers are big fans as well. The point-of-sale loans are easy for retailers to manage, and research shows these options lead to bigger baskets and greater customer loyalty. RBC Capital Markets estimates a BNPL option increases retail conversion rates 20% to 30%, and lifts the average ticket size between 30% and 50%.

Adding incremental sales

“It’s all about incrementality,” said Russell Isaacson, director of retail and automotive lending at Ally Lending, “getting that incremental sale or incremental consumer.”
Installment payments give consumers options and convenience when it comes to managing budgets and purchasing, according to Hemal Nagarsheth, associate partner in Kearney’s financial services practice. He said the option also increases trust between retailers and consumers, leading to “incremental sales, higher average purchase sizes, and higher frequency of purchase.”
Buy now pay later payment plans, offered by companies like Affirm, Australia-based Afterpay and Sweden’s Klarna, are particularly attractive to younger shoppers, like the much-desired Gen Z and millennial consumer. While each plan has differences — from the number of payments to the specific terms — the key similarity is the promise of a handful of equal payments spread over a relatively short period of time, with no hidden fees. Often, the plans are interest-free.

Installment payments are more popular among consumers that either do not have access to credit, or for a variety of reasons, do not want to purchase with a credit card. The option also makes a lot of sense for shoppers who don’t have the funds to cover the total purchase, but will over the next several paychecks, according to Ally Lending President Hans Zandhuis.

The average transaction value is about $200 for a buy now, pay later purchase, said Zandhuis. Often the checkout value for the retailer would have been around $100 had the ability to pay later not been available, he said. With it, that same consumer can spend $175 to $200, with 4 monthly payments of $50. The payments are meant to align with paycheck cycles.
Take apparel retailer Rue21, for example. Its key demographic is an 18- to 25-year-old female shopper, who often doesn’t use credit cards. With many low-priced items on its website, and waning mall traffic, increasing average order volume is a key priority.
When the pandemic shuttered stores, Rue21 had to figure out how to sell to its shoppers online without credit. Since Rue21 added Klarna as a payment option in-store and online, its average order volume is 73% greater than other payment methods, according to a case study Klarna published. Rue21 shoppers that transact with Klarna turn in the highest sales per customer with a 6% higher purchase frequency. As of May, Klarna purchases made up more than a quarter of rue21’s e-commerce sales.

A logo sign outside of a rue21 retail store location in Chambersburg, Pennsylvania on January 25, 2019.
Kristoffer Tripplaar | Sipa via AP Images

Affirm boasts that its merchant clients report a 85% increase in average order value when consumers opt to use its BNPL plan over other payment methods. Affirm approves installment payments for purchase totals as high as $17,500, which has proven to be very important for Peloton’s expensive workout equipment and services. FT Partners, an investment bank focused on the fintech space, estimated 30% of Affirm’s first-quarter 2021 revenue came from sales on Peloton’s website.
Klarna’s merchant base reports a 45% increase in average order value when a shopper pays over four payments. Shoppers can also opt to pay in full in 30 days interest-free, or for larger purchase, get financing with monthly payments from 6 to 36 months with an annual percentage rate of between 0% and 29.9%.

New customers

Attracting a customer a retailer might not have swayed otherwise is another benefit of offering a buy now, pay later options.
Earlier this year, Macy’s CEO Jeff Gennette told investors its partnership with Klarna was helping it to attract new customers.
“We launched Klarna on the Macy’s website in October [2020] and we’ve since scaled it across Macy’s, Bloomingdale’s and Bluemercury, both online and in stores,” he said. “With Klarna, we continue to see higher spend per visit and increased acquisition of new younger customers, 45% are under 40. Our goal is to convert all of these new customers to Macy’s loyal customers, who return for future purchases.”
Around 93% of Afterpay’s gross merchandise value in the most recent fiscal year comes from repeat users of the installment payment service, with the longest-tenured consumer making 30 more transactions per year.

Higher conversion

Installment payments allow the retailer to “convert a [consumer’s] wish into a sale” according to Chris Ventry, vice president at global consultant group SS&A company. “It eliminates the ability-to-pay roadblock” said Ventry. “For those using debit cards, the potential for an extended interest-free payment schedule through BNPL is enticing, ultimately enticing enough to drive conversion, which is the primary goal of all digital commerce sites.”
An analysis by Similarweb of the top 100 U.S. fashion and retail websites compared 50 merchants that offer a buy now, pay later option at checkout and 50 that do not. On average, sites with a BNPL option saw a conversion rate of 6% compared with 4% for those that do not.
Afterpay said it increases a retailer’s conversion rate and incremental sales 20% to 30% more than other payment options.
The incremental revenue and increased conversion makes the incremental transaction cost the retailer pays to the fintech companies worth it too. Zandhuis said while the retailer pays an additional 2% higher transaction fee to the BNPL company compared with transaction fees a traditional credit card company charges, “the math speaks for itself. The extra revenue is higher than the cost.”
Afterpay and Klarna charge merchants a 3% to 5% transaction fee, Affirm declined to disclose its transaction fees.
The programs also have advantages compared with traditional layaway, which requires retailers to store purchased items on site while customers make installment payments over time. Increasingly retailers are using stores as mini-fulfillment centers to service online orders. In this model, store space is at a premium.

Growth opportunity

Buy now, pay later is the fastest growing e-commerce payment method globally, with the growth of digital wallets second, according to FIS Worldpay. In 2019, the $60 billion BNPL market represented 2.6% of global e-commerce, excluding China.
Worldpay estimates that use of the option could grow at a compound annual growth rate of 28% to reach $166 billion by 2023. At that pace, it would make up about 5% of global e-commerce outside of China.
Right now, BNPL makes up less than 2% of North American sales, according to FIS WorldPay.
Coresight senior analyst John Harmon acknowledges the opportunity for retailers, but does not see it as a panacea.
“I don’t see BNPL as a magic solution, despite its booming acceptance, since it is just credit of a different sort,” Harmon said.

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There remains little evidence that workers who lost federal unemployment benefits in June or July have rushed to find jobs, according to labor economists.
Data suggests factors aside from enhanced benefits, like health and child care, have impacted the labor market to a larger degree.
The dynamic suggests the Labor Day unemployment cliff may also not provoke a surge of job growth.

A person reads a list of employers as they attend a job fair at SoFi Stadium on Sept. 9, 2021, in Inglewood, California.
PATRICK T. FALLON | AFP | Getty Images

There remains little evidence that states successfully nudged people back to work by ending federal unemployment benefits early, according to economists.
Twenty-six states withdrew pandemic-era jobless support in June or July. Their governors, predominantly Republican, believed enhanced jobless aid offered an incentive to stay home instead of work.

Data suggests other factors are playing a larger role, according to economists. They cite ongoing health concerns, child-care issues and expanded savings among a host of issues sidelining workers even amid record job openings.
Federal benefit programs officially ended on Labor Day in the remaining states. This “unemployment cliff” impacted more than 8.5 million people, who lost all their benefits, Labor Department data issued Thursday suggests.
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Workers’ muted response to the first unemployment cliff (i.e., in the states that withdrew early) suggests the Labor Day end also won’t provoke a surge of job growth, according to economists.
“If that’s any sort of precursor, I’m not betting on the end of the federal benefits [on Labor Day] being a real clear and sharp inflection point,” AnnElizabeth Konkel, a labor economist at job site Indeed, said.

State economies differ (in terms of job mix and worker demographics, for example), making comparisons and predictions difficult, she said.

‘Pressing issue’

Understanding how the unemployment cliff will impact the U.S. labor market is a “pressing issue,” according to a JPMorgan Chase Bank research note published Thursday and authored by economist Peter McCrory.
For example, those unable to find a job or return to work may struggle financially and pull back on spending, perhaps negatively impacting local economies.
Most people (7 in 8) who lost federal aid in June were not reemployed by early August, according to a paper authored by researchers at Columbia University, Harvard University, the University of Massachusetts Amherst and the University of Toronto last month. That led to a nearly $2 billion aggregate spending cut, they found.

JPMorgan economists have also “failed to find large effects” on jobs among early withdrawal states since mid-June, McCrory wrote. He examined data like monthly state employment metrics and weekly claims for unemployment benefits, as well as alternative measures like restaurant dining and Google job searches.
“In fact, we find that the loss of benefits is associated with a modest decline in employment growth, earnings growth, and labor force participation,” McCrory wrote.
While a “flood” of workers to the job market hasn’t materialized so far in those states, it’s still too early to understand if the impact will be similar in states where federal benefits ended on Sept. 6, according to Daniel Zhao, a senior economist at job site Glassdoor. (Sept. 6 was the official expiration provided by the American Rescue Plan, which Congress didn’t extend.)

There are reasons to believe the impact may be more pronounced in the remaining half of states, he said. For one, the Labor Day cliff (which impacted big states like California and New York) affected a larger volume of workers than the one over the summer, perhaps making it easier to spot job impact in available data, he said.
But the Covid delta variant (and its associated spike in cases) may be making unemployed workers nervous and leading employers to struggle finding people for open positions, especially for in-person work, economists said. Elevated caseloads may also be impacting parents’ ability to return to work due to school closures or student quarantines, for example.
Americans are still sitting on elevated savings, perhaps partly due to enhanced benefits, allowing unemployed workers more time to find the best-fitting job, Zhao said. (Other government aid and cutbacks on in-person activities may have also helped bolster savings during the pandemic.)

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New documents revealed in a lawsuit allegedly show internal conversations between executives during the height of January’s meme-stock chaos.
In one instance, Robinhood Chief Operating Officer Gretchen Howard acknowledges that the start-up was facing a “major liquidity crisis,” according to the suit. Publicly, the company’s chief executive was saying the opposite.
“This clearing thing seems pretty scary to me. I would say this is our biggest fire right now,” Robinhood’s director of engineering said in a Slack message, according to the lawsuit.

Vlad Tenev, CEO and Co-Founder of Robinhood, in his office on July 15, 2021 in Menlo Park, California.
Kimberly White | Getty Images Entertainment | Getty Images

Robinhood executives had a lot to talk about the week Reddit users were driving a historic short squeeze in GameStop.
New documents in a lawsuit allegedly show internal conversations between executives panicking over how to meet financial requirements, debating the severity of a Reddit-driven short squeeze and contradicting the CEO’s public statements.Plaintiffs in the claim, which was filed in the U.S. District Court in the Southern District of Florida, allege they suffered damages when Robinhood enacted trading restrictions on Jan. 28 amid volatile activity in GameStop and other meme stocks. They are suing for damages, interest and attorneys’ fees. Plaintiffs are also seeking class action status.

“As a brokerage firm, we have many financial requirements, including SEC net capital obligations and clearinghouse deposits,” the brokerage said in a Jan. 28 blog post addressing the trading restrictions. “Some of these requirements fluctuate based on volatility in the markets and can be substantial in the current environment.”According to the suit, in one instance, Robinhood Chief Operating Officer Gretchen Howard messaged internally that the start-up was facing a “major liquidity crisis.” Publicly, the company’s chief executive said the opposite.
“There was no liquidity problem,” CEO Vlad Tenev told CNBC’s Andrew Ross Sorkin a day later, on Jan. 29.
A Robinhood spokesperson said the start-up met its liquidity obligations on January 28, and “fully satisfied its clearinghouse deposit requirement before the market opened.”

Sharp rise in trading volume

Robinhood and other brokerage firms saw unprecedented trading volume in January around heavily shorted stocks, including GameStop and AMC. The brokerage start-up, which has to deposit money to a clearinghouse based on the volume of trades, said it restricted buying of certain securities because the firm was unable to meet deposit requirements. These requirements increase when volatility goes up in case of large losses by options trades.
“This clearing thing seems pretty scary to me — I would say this is our biggest fire right now,” Robinhood’s director of engineering allegedly said in a Slack message, adding that the company could see a margin call of hundreds of millions of dollars. “In the worst case scenario we max out our credit lines and they liquidate our positions.”

According to the suit, David Dusseault, chief operating officer of subsidiary Robinhood Financial, said the company was “to [sic] big for them to actually shut us down,” referring to the National Securities Clearing Corp., a provider of centralized clearing services. In the same conversation, another executive, whose name is redacted, said “we’re going to get crucified” for stopping trades, according to the complaint.

‘A tidal wave of volume and volatility’

The chats were part of the discovery process in a lawsuit against Robinhood. An attorney for the plaintiffs argued that Robinhood knew the Reddit-driven chaos was coming and didn’t do enough.
“Robinhood and its higher-ups were well aware of this tidal wave of volume and volatility that was heading in their direction,” Maurice Pessah, founder of Pessah Law Group, told CNBC. “In our opinion and as we allege in the lawsuit, they didn’t do their jobs and what they are required to do in terms of analyzing risks and managing risks as a broker.”
In response, Robinhood said it disputes the plaintiff allegations and stands by public statements regarding Jan. 28. A company spokesperson also said “the communications are consistent with Robinhood’s focus to take appropriate, incremental measures to mitigate risk.”
In another excerpt, data scientists and Tenev debated how intense the Reddit frenzy could get, according to the suit.
“Maybe I am being alarmist but I think we should consider all-hands on deck kind of situation and shuffle some priorities to deal with increasing volumes,” Robinhood’s director of engineering allegedly wrote. The company’s head of data science responded “you may not be being an alarmist” after seeing a chart showing the spike in volume, plaintiffs alleged.
“Today was a huge day. There are internal things that are starting to buckle under pressure,” another software engineer said, according to the suit.
Tenev allegedly responded that “only the paranoid survive.” His response to a comment that “one who panics first panics best” was “joy.”
In another message, the company acknowledged “blowback from this is going to be exponentially worse as time goes on” and they “were worried about the long term affects [sic] of this,” according to the suit.
In the months that followed these conversations, Robinhood’s CEO as well as the CEOs of Citadel and Melville Capital testified in front of Congress. Tenev told the representatives that the GameStop mania was a 1 in 3.5 million event, which he called “unmodelable” and that Robinhood’s risk management processes kicked in as they were meant to. In order to meet capital requirements and shore up its balance sheet, Robinhood raised more than $3.4 billion in a matter of days.
The company went on to a blockbuster public listing in August.
Securities and Exchange Commission Chair Gary Gensler is expected to publish a report on the GameStop saga in the coming weeks, as well as recommendations on what, if any, changes should be made to the U.S. trading system as a result.

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The Carnival Cruise Ship ‘Carnival Vista’ heads out to sea in the Miami harbor entrance known as Government Cut in Miami, Florida June 2, 2018.
RHONA WISE | AFP | Getty Images

Check out the companies making headlines in midday trading.
Carnival — Carnival shares rose 3% after the cruise line said voyages for the third quarter were cash flow positive and expects this to continue. Shares of Norwegian Cruise Line gained about 3% and Royal Caribbean added 2.8%.

Match Group — Shares of Match Group rose about 4% after the online dating platform announced on Thursday that it will sell shares of its common stock in a registered direct offering. The price per share and number of shares of common stock issued will be calculated by a volume-weighted average price during a five-day averaging period starting Friday, the company said.
Merck — Shares of the pharmaceutical giant rose 0.8% on Friday after Merck and AstraZeneca announced that treatment using the drug Lynparza showed positive results in a phase-three trial. The trial results suggest that the treatment slows the progression of prostate cancer and show a trend toward increased survival, the companies said.
Nike — The apparel stock fell 6.3% after Nike cut its full-year guidance for sales growth. The company said supply chain issues in Vietnam were slowing sales. Nike now projects mid-single-digit revenue growth for its 2022 fiscal year, down from prior guidance of low-double-digit growth.
Costco — Shares of the retailer jumped 3.3% following Costco’s fourth-quarter results. The company beat top- and bottom-line estimates during the quarter, earning $3.90 per share excluding items on $62.68 billion in revenue. Analysts surveyed by Refinitiv were expecting $3.57 per share on $61.3 billion in revenue.
Salesforce — Salesforce extended its Thursday gains, rising 2.8% after Piper Sandler upgraded the stock to overweight from neutral, saying it’s confident the company could see “a multi-year period of multiple and profit expansion.” The stock jumped on Thursday after the software company raised its full-year 2022 revenue guidance.

Coinbase — Shares of the cryptocurrency exchange slid about 2.4% even after Needham reiterated the stock as a buy. Cryptocurrencies plunged Friday morning on news that China is issuing yet another crypto crackdown. Coinbase derives 90% of its revenue from retail transactions, which is highly correlated with crypto asset prices, according to Needham, so its stock price tends to move in tandem with cryptocurrencies.
Cheesecake Factory, Dave & Buster’s — Cheesecake Factory and Dave & Buster’s added 5.1% and 4.3%, respectively, after Jefferies upgraded the restaurant stocks to buy from hold. “We are incrementally more positive on the full service category following delta/inflation sell-off and exuberant Consensus forecasts reigned in,” Jefferies said.
Roku — Roku shares fell 3.8% after Wells Fargo downgraded the video streaming platform to equal weight from overweight. Wells Fargo said rising competition makes expectations for Roku’s revenue growth likely too high.
— CNBC’s Jesse Pound, Pippa Stevens and Tanaya Macheel contributed reporting

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The price of bitcoin fell 8% to $41,241, according to Coin Metrics data.
Ethereum, the second-largest digital currency, fell 11% to $2,808.
The declines come after the People’s Bank of China said all crypto-related activities are illegal.

Bitcoin and ethereum tumbled Friday, with traders rattled by tough talk out of China.
The price of bitcoin fell 8% to $41,241, according to Coin Metrics data. Ethereum, the second-largest digital currency, dropped 11% to $2,808.

It comes after the People’s Bank of China said in a Q&A that all crypto-related activities are illegal. Services offering trading, order matching or derivatives for virtual currencies are strictly prohibited, the PBOC said, while overseas exchanges are also illegal.
Beijing has cracked down sharply on crypto this year. The Chinese government moved to stamp out digital currency mining, the energy-intensive operation that validates transactions and produces new coins. That led to sharp slump in bitcoin’s processing power as miners took their equipment offline.
The PBOC banned banks and non-bank payment institutions like Alibaba affiliate Ant Group from providing services related to virtual currency. In July, authorities told a Beijing-based software company to shut down over its involvement with crypto trading.
Vijay Ayyar, head of Asia Pacific at digital currency exchange Luno, said that, though China’s position on crypto was not new, it was enough to tip the market into negative territory. Investors had already been unnerved by the U.S. Securities and Exchange Commission taking a tougher line on cryptocurrencies lately, he added.
“The Chinese regulators have always been extreme in their views and these comments are not new,” Ayyar told CNBC via email. “They have said these things many times in the past. But the reaction is interesting purely because we are anyway in a slightly nervous environment for crypto with the recent SEC comments and overall macro environment with the Evergrande news. So any comments of this nature will cause a sell off in risky assets.”
“Overall, we’ve seen this play out many times in the past, with such dips being inorganic and bought up quite quickly especially in environments where crypto is in a bull market cycle. Hence, price action wise, as long as we don’t drop below $38,000 on a high time frame basis, we are still in bullish territory.”

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The People’s Bank of China said services offering trading, order matching, token issuance and derivatives for virtual currencies are strictly prohibited.
Overseas cryptocurrency exchanges providing services in mainland China are also illegal, the PBOC said.
It’s not the first time China has gotten tough on cryptocurrencies. Earlier this year, Beijing announced a crackdown on crypto mining.

In this photo illustration, the Bitcoin logo is seen on a mobile device with People’s Republic of China flag in the background. (Photo Illustration by t/SOPA Images/LightRocket via Getty Images)
Budrul Chukrut | SOPA Images | LightRocket | Getty Images

China’s central bank renewed its tough talk on bitcoin Friday, calling all digital currency activities illegal and vowing to crack down on the market.
In a Q&A posted to its website, the People’s Bank of China said services offering trading, order matching, token issuance and derivatives for virtual currencies are strictly prohibited. Overseas crypto exchanges providing services in mainland China are also illegal, the PBOC said.

“Overseas virtual currency exchanges that use the internet to offer services to domestic residents is also considered illegal financial activity,” the PBOC said, according to a CNBC translation of the comments. Workers of foreign crypto exchanges will be investigated, it added.
The PBOC said it has also improved its systems to step up monitoring of crypto-related transactions and root out speculative investing.

“Financial institutions and non-bank payment institutions cannot offer services to activities and operations related to virtual currencies,” the bank said, reiterating past comments.
The price of bitcoin sank over 3% on a 24-hour basis, last trading at around $42,239, according to Coin Metrics data. Ethereum, the second-largest digital asset, fell 7% to $2,860.
Stocks with heavy exposure to crypto also slumped in premarket trading, with Coinbase down by nearly 4%, MicroStrategy slipping 5% and Riot Blockchain down over 6%.

It’s not the first time China has gotten tough on cryptocurrencies. Earlier this year, Beijing announced a crackdown on crypto mining, the energy-intensive process that verifies transactions and mints new units of currency. That led to a sharp slump in bitcoin’s processing power, as multiple miners took their equipment offline.

Read more about cryptocurrencies from CNBC Pro

The PBOC also ordered banks and non-bank payment institutions like Alibaba affiliate Ant Group not to provide services related to crypto.
In July, the central bank told a Beijing-based company to shut down for allegedly facilitating digital currency transactions with its software.
China’s crypto crackdown comes as Beijing is looking to fulfill its climate targets. The country is the world’s biggest carbon emitter, and has set out to become carbon neutral by 2060.
Meanwhile, the PBOC is also working on its own digital currency. China is seen as a leading contender in the race toward central bank-issued digital currencies, having trialed a virtual version of the yuan in several regions.
—CNBC’s Evelyn Cheng contributed to this report.

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Regulators cracked down on Chinese ride-hailing app Didi, then after-school tutoring companies, this summer.
In both cases, investment funds poured in billions of dollars for a strategy of cash burning to subsidize exponential user growth and build up a dominant market leader.
Now, investors need to consider national policies far more than just industry developments, Ming Liao, founding partner of Beijing-based Prospect Avenue Capital.

Chinese ride-hailing company Didi offers cars for guests of the Annual Meeting of the New Champions 2017 (World Economic Forum’s Summer Davos session) on June 27, 2017, in Dalian, Liaoning Province of China.
VCG | Visual China Group | Getty Images

BEIJING — As overseas investors reel from Beijing’s regulatory crackdown, the rapid fallout in an industry like after-school tutoring can be a guide to what went wrong, and where future opportunities lie in China.
Before China cracked down on tutoring schools this summer, major investment firms like SoftBank were pouring billions of dollars into Chinese education companies, many of which were publicly traded in the U.S. or on their way to listing there.

The strategy was one of burning cash to fund exponential user growth, with hopes of profit in the future. For the strategy to work, investors aimed for a “winner takes all” approach that they’d used with other Chinese start-ups such as coffee chain Luckin Coffee and ride-hailing company Didi.
Didi essentially paid Chinese consumers to take cheap rides through its app, beating out Uber to dominate about 90% of the mainland market, and went on to raise more than $4 billion in a New York IPO on June 30.
But it soon became clear that investment strategy might no longer work. Just days after Didi’s IPO, Chinese authorities ordered app stores to remove Didi’s app and began investigations into data security — effectively shutting down the business’s growth prospects in the near term.
It came months after Beijing’s efforts to tackle alleged monopolistic practices by the country’s internet technology giants like Alibaba and Tencent.
By late July, the education sector was clearly Beijing’s next target.

Crackdown on after-school tutoring

In October 2020, online tutoring start-up Yuanfudao said it raised a total of $2.2 billion from Tencent, Hillhouse Capital, Temasek and many other investors — for a valuation of $15.5 billion.
Two months later, competitor Zuoyebang raised $1.6 billion from investors including SoftBank’s Vision Fund 1, Sequoia China, Tiger Global and Alibaba.
“They were hoping to create another oligopoly like Didi” with market pricing power, said an investor and co-founder of one of the largest U.S.-listed Chinese education companies, according to a CNBC translation of his Mandarin-language interview. He requested anonymity because of the sensitivity of the matter.
However, the education industry already had several major market players, he pointed out, and “it turned out that no business could really beat the other before the crackdown.”
Building a dominant market leader in after-school tutoring was a lucrative prospect. The opportunity was enormous given China’s population of 1.4 billion people and a culture in which parents prize their children’s education.
Early industry players like New Oriental got their start with physically leased locations and in-person classrooms. But the coronavirus pandemic in 2020 accelerated the tutoring industry’s shift online, and the cash-burning fights of China’s internet world was in full play.

Advertising wars

Chinese after-school tutoring companies began to spend heavily last year on advertising to attract new students.
U.S.-listed Gaotu spent more than 50 million yuan ($7.75 million) in one week this past winter for ads on short-video platform Kuaishou, a person familiar with the matter told CNBC.
“In China, Kuaishou is a smaller platform than [ByteDance’s] Douyin/TikTok, so the total spend on traffic by all of K to 12 education companies would be much more than that,” the source said in Mandarin, according to a CNBC translation.
Gaotu did not respond to a request for comment. In its earnings report for the first three months of the year, the company said its selling and marketing expenses of 2.29 billion yuan were three times more than a year ago.
Tal Education disclosed that its spending in the same category surged by 172% from a year ago to 660.5 million yuan for the three months that ended Feb. 28.
Both companies reported a net loss in the quarter, as did another industry player, OneSmart International Education Group, which disclosed a 47% year-on-year surge in selling and marketing expenses to 288.8 million yuan.

OneSmart listed in the U.S. in 2018 in an IPO underwritten by Morgan Stanley, Deutsche Bank and UBS. Later that year, the education company acquired Juren, one of the oldest businesses in China’s tutoring industry.
But the new after-school regulations struck a fatal blow to the 27-year-old company. About a month after the new rules were released, Juren collapsed, just one day before public schools opened on Sept. 1.
OneSmart could be delisted from the New York Stock Exchange since its shares have remained below $1 since July.
Other U.S.-listed Chinese stocks are also struggling. New Oriental did not report a net loss for the quarter ended Feb. 28, but disclosed it spent $156.1 million on selling and marketing in that time, 32% more than a year ago.
The surge in advertising spend to grow student enrollment came as investors piled into the industry, and increased competition sent customer acquisition costs soaring.

The landscape has significantly changed.

founding partner, Prospect Avenue Capital

‘Common prosperity’ in China

The new policy marks Beijing’s latest effort to restrict the education industry’s sprawling growth and its burden on parents — a concern for authorities trying to boost births in the face of a rapidly aging population and shrinking workforce.
Investors need to recognize that tackling the population problem, slowing economic growth and tensions with the U.S., have become top concerns for the Chinese government, said Ming Liao, founding partner of Beijing-based Prospect Avenue Capital, which manages $500 million in assets.
“The landscape has significantly changed,” he said, noting that investors now need to consider national policies far more than just industry developments.

In addition to the crackdown on internet companies and after-school tutoring centers, authorities have  ordered online video game companies to restrict children to playing three hours a week.
Speeches by President Xi Jinping have emphasized the goal is “common prosperity,” or moderate wealth for all, rather than some.
Education is just one of the so-called three mountains that Chinese authorities are tackling. The other two are real estate and health care, all areas in which hundreds of millions of people in the country have complained of excessively high costs.
In the last 20 years, corporate profits have largely gone to property developers and companies based on internet platforms, Liao said.
In light of new policy priorities, he said, it’s important for investors to distinguish between internet-based businesses and those developing more tangible kinds of technology like hardware — even if both kinds of companies are loosely referred to as “tech” businesses in English.

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With the U.S. now under President Joe Biden and bent on competing with China, Beijing is increasing investing in an ambitious multi-year plan to build up its domestic technology ranging from semiconductors to quantum computing.
The “China market can still offer attractive investment returns for global investors, and the challenge lies in identifying the potential future winners amid China’s rebalancing,” Bank of America Securities analysts wrote in a Sept. 10 report.
They pointed to a shift over the last two decades in the largest Chinese companies by market capitalization — from telecommunications, to banks, to internet stocks. Going forward, they expect greater regulation on internet and property industries, “while advanced manufacturing, technology, and green energy related sectors will be promoted.”
The bank listed a few contenders for “future winners.”

Sportswear: Anta
Health care: Wuxi Bio
Electric vehicles and and EV battery: BYD
Lithium in new materials: Ganfeng
Renewable energy: Long Yuan
Tech hardware: Flat Glass

“Certain industrials sectors that we currently do not cover could also have promising opportunities,” the analysts said.

Future of investing in China

For Chinese after-school tutoring companies that once attracted billions of dollars, they’re now trying to survive by building up courses in non-academic areas like art or adult education. Those in the industry say it’s an uncertain path that has a market only a fraction of what the companies used to operate in.
SoftBank is waiting for clarity on the regulatory front before resuming “active investment in China,” its Chief Executive Masayoshi Son said in an earnings call on Aug. 10.
“We don’t have any doubt about future potential of China … In one year or two years under the new rules and under the new orders, I think things will be much clearer,” Son said, according to a FactSet transcript.

When contacted by CNBC last week about its investment plans for China, Softbank pointed to how it led investment rounds in the last few weeks in Agile Robots, a Chinese-German industrial robotics company, and Ekuaibao, a Beijing-based enterprise reimbursement software company.
“Our commitment to China is unchanged. We continue to invest in this dynamic market and help entrepreneurs drive a wave of innovation,” SoftBank said in a statement.
But when it comes to bets on the education industry, some investors have decided to look elsewhere in Asia.
In June, Bangalore-based online education company Byju became the most valuable start-up in India after raising $350 million from UBS, Zoom founder Eric Yuan, Blackstone and others. Byju is valued at $16.5 billion, according to CB Insights.

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