Don’t look down!
The recent rally in A-share valuations has been remarkable even for China’s notoriously volatile mainland bourses. The last boom-bust cycle led to a freeze on IPOs, as well as sweeping reforms. Can investors avoid another all-too predictable correction?
Ample liquidity and buoyant investor sentiment have sent China’s stock markets to their highest levels since the initial stages of the financial crisis in early 2008. The sustained rally is encouraging more companies to sell shares locally rather than in Hong Kong or the US, even at the expense of artificially low IPO prices.
Beijing Baofeng Technology, the first internet company to remove a Variable Interest Entity (VIE) structure to list domestically, provides a vivid example of why the A-share market is so attractive.
The online video company had to price its March IPO on the Nasdaq-like ChiNext at an 85% discount to its quoted peers because of Chinese restrictions on listing valuations, to raise just Rmb214m (US$34m) as a result.
However, the stock has rocketed more than 34-fold since trading began. As of May 20, the company was valued at Rmb36bn, more than its much larger US-listed rival Youku Tudou and nearly seven times bigger than Xunlei, another US-listed competitor.
Chinese regulators, keen to stem the tide of technology stocks heading to the US, could not hope for a better showcase.
As part of its IPO reforms, China has been working on the first major amendment to securities law in a decade to allow unprofitable companies to list domestically. Officials at the China Securities Regulatory Commission and individual stock exchanges say the amendment is intended to allow internet and other strong growth technology companies to tap domestic capital markets.
“Many large-cap state-owned enterprises were already listed in the last round of the bull market. In the future, more sizable IPOs may come from high-growth companies in emerging industries,” said Kefei Li, head of ECM for China at UBS.
“On a 10-year prospective, the CSI-300 is still reasonable on both PE and PB. However, the level of margin financing has run up very quickly to about 16% of turnover in Shanghai and Shenzhen exchanges at the end of March, which means there are many weak hands in the A-share market should there be a meaningful correction.”
The Shanghai Stock Exchange recently said it planned to open a strategic emerging enterprises board to facilitate market access for start-ups in the computer, information technology, internet and biopharmaceutical industries.
The move may help cool the overheated ChiNext market, which is trading at the highest level since it was established in 2009 and has notched a gain of around 120% year to date.
“The potential launch of Shanghai’s strategic emerging enterprises board will help to digest the huge investor demand for high-growth companies in emerging industries, which can effectively ease the bubble in ChiNext market,” said Steve Yang, A-share strategist with UBS Securities.
Until recently, Chinese issuers were reluctant to list domestically due to a year-long IPO freeze in 2013 and overloaded pipelines. However, since the beginning of the year, IPOs have multiplied on the back of the stock rally.
Markets in Shanghai and Shenzhen have risen about 33% so far this year and doubled in value since last June.
The Shanghai Stock Exchange surpassed the Stock Exchange of Hong Kong and even the mighty New York Stock Exchange to become the world’s most active bourse for IPOs in the first quarter of the year, according to Deloitte China.
China’s two bourses, the Shanghai Stock Exchange and the Shenzhen Stock Exchange, saw 70 A-share IPOs with total value of Rmb48.3bn during the quarter, up 44% from a year earlier, Deloitte said.
The market is on course for a good second quarter after the CSRC began stepping up its approval of IPOs in April and allowed bigger deals to come to the market.
Following the Rmb10.03bn listing of Orient Securities in March, China National Nuclear Power is set to seal the biggest A-share IPO in five years at around Rmb14.5bn.
In an effort to allow more companies to come to market for lower individual amounts, the CSRC removed its restriction on IPO sizes in favour of a valuation limit instead. Since last June, no company has sold shares at multiples above 23 times historical earnings.
CSRC chairman Xiao Gang said in March that China would transform the current IPO approval system into a registration-based mechanism once the amendment to the securities law was enacted. Investors expect the move to simplify the listing process and further accelerate the pace of IPOs.
In the eyes of many, Chinese stocks are no longer cheap, especially in the context of the country’s slowest economic growth in six years. With many valuations far above fundamentals, regulators have to worry about a possible stock bubble that could burst at any time.
“On a 10-year prospective, the CSI-300 is still reasonable on both PE and PB. However, the level of margin financing has run up very quickly to about 16% of turnover in Shanghai and Shenzhen exchanges at the end of March, which means there are many weak hands in the A-share market should there be a meaningful correction,” said Wendy Liu, head of China equity research at Nomura.
A major correction may prompt regulators to shut down the IPO market again in a repeat of history.
According to Liu, there are indications that Beijing has been trying to tame the bull market since mid to late April. In the past several weeks, the CSRC has repeatedly warned of market risks and pushed brokerages to deleverage in order to stem the surge of margin trading.
“Generally, Chinese regulators set a goal and apply various measures to achieve those goals. So, give them some time, they will try to make a steady bull out of this occasionally mad bull,” said Liu.
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