We Don't Need No (For-Profit) Education. ESG, China-style.

The latest policy decree from Beijing has conferred a death sentence on the for-profit education sector in China. Friday saw ADRs for New Oriental Education and GSX Techedu crater over 60% on the NYSE.

The new policy prevents after-school tutoring firms from operating as “for profit” enterprises. For those outside China, this new policy could feel ad-hoc; it provides another example of the regulatory risk one faces when investing in Chinese stocks. It may also appear the Chinese government is targeting yet another profitable industry in China after fintech and consumer tech. However, this latest regulatory action is unique in its implication for ESG investors. It is a fascinating case study regarding the difference between Chinese and American regulators that provides insight into Beijing’s approach to ESG.

The hottest buzz word in China—a word that captures the true zeitgeist of the country—is “involution”. It speaks in part to the stress of the investment-banking style, 100-hour work week that young children (or their parents) feel is required to earn spots at top high schools and universities (or in some cases, elementary schools). The “education industry”, often referred to as “cram schools”, have profited enormously from this phenomenon. In fact, it would not be incorrect to argue that cram schools play a huge role in perpetuating and accentuating this problem. 

It is broadly believed that cram schools don’t teach students useful skills—that is, they don’t help students become creative problem solvers or develop the ability to research and think critically. In short, they do not provide students with useful and employable skills. Cram schools essentially specialize in (1) providing a vast test bank for students to practice repeatedly and (2) teaching techniques for providing correct answers without the need for deep understanding or insight. Cram schools have always been problematic for educators for obvious reasons. They work against educators, against the spirit of education, and against the function of educational institutions.

Despite general awareness of the problem, it is a difficult one to solve. This is partly because cram schools are darn effective. And as you might expect, they are also very expensive. As parents, if you have the money and you are willing to discipline your children into long hours of practice exams and rote memorization—your children will have an enormous advantage in ultimately gaining admissions to top universities. The fact that wealth plays such an enormous role in admissions to elite public schools is clearly a social problem in China. And the fact that admissions favor rote memorization of test bank questions and test-taking tricks also creates a problem for university educators. 

This problem isn’t unique to China. It has been recognized as a major social problem in Japan, Taiwan and Korea. In fact, my parents chose immigration to the U.S. to help my sister and me escape the very same cram school culture in Taiwan. If you don’t pay up to go to cram schools, your chance of admission to a good high school and ultimately a good college falls precipitously to zero. Various Asian countries have attempted to thwart the cram school culture by changing the national entrance exams or changing the admissions process—but for every new admissions criterion added, a new premium cram school program arises to give paying students an edge. The high suicide rate amongst junior high and high school students in Asia is significantly attributed to this unhealthy and unfair test-taking competition spurred on by the cram school industry. In fact, a major concern voiced by potential parents in Asia for not wanting to have children is the extraordinary financial and human cost associated with navigating competitive educational practices including cram schools. You are damned if you play the game, and you’re damned if you don’t. This is at the very heart of “involution”. Everyone is worse off from playing this game. But no one can afford not to play it.

This brings us back to the regulator in China. Accustomed to playing the hero to its citizens, the Chinese regulator has jumped in to solve this problem as bluntly as it knows how—by forcing cram schools to become non-profits. With this move, Beijing hopes that cram schools will either (1) transform into progressive entities focused on providing after-school assistance to those who have fallen behind due to illness or other reasons or (2) shut down operations and cease preying on students and parents in hungry pursuit of profits. While Beijing might have preferred for the financial market to divest for-profit education and cripple their share prices in the name of ESG, Western ESG standards are simply not built to address this uniquely Asian social problem. What the free market cannot fix, Beijing is more than willing (eager even) to step in and address. Beijing could not be singing the message any more clearly: “Hey! Companies! Leave them kids alone!”

The failure to understand the social externalities created by these highly profitable Chinese cram schools and to understand China’s willingness to act to address this social problem caused many investors to misjudge the regulatory risk these firms faced. But where do we go from here? Where should we expect Beijing to sweep next with its superhero cape on?

What’s clear is that firms which profit from activities that are deemed to generate substantially negative social externalities are likely to face black swan policy risk. Firms that create addictive mobile games draped in sex and violence targeting young adults, firms that are big polluters, firms that target students with predatory loans, financial institutions that guarantee high returns without the proper balance sheet strength, etc.—these are likely to be in the crosshairs of Chinese regulators. 

China is offering us an interesting and radically different lens through which to consider ESG.  If there was ever a clear argument for superior return from ESG investing, it was about avoiding regulatory risk. Green investing makes sense if you expect unfriendly policy toward coal and fossil fuel usage. Avoiding tobacco stocks makes sense if you expect greater government taxes and other disincentives put into place to discourage smoking. In China, understanding the ESG issues (carbon neutrality, reducing cost of raising children, reducing wealth inequality) that Beijing cares about and is likely to act on will meaningfully reduce one’s portfolio risk.

Clearly, Beijing’s authoritative approach to regulating its industries to achieve social objectives is not one that most global investors are familiar with, or even comfortable with.  Setting aside judgment about Beijing’s preference for regulation over the invisible hand, to be a successful investor, global investors need to understand China’s ESG objectives and Beijing’s approach to addressing them -- even if they don’t always appreciate them.