China's IPO Drought: Will it Lift?

Following a flood of initial public offerings (IPOs) that lasted several years, China’s local A-share market has been in an IPO drought since late last year. There is some speculation China’s regulatory body, the China Securities Regulatory Commission (CSRC), may allow some IPOs to trickle back into the market this year, but we don’t yet know exactly when or at what volume. I’ve invited my colleague Eddie Chow to share his perspective on why IPO issuance has been halted in China’s local market, and where we see potential opportunities in the current environment.

In the past year or so, the performance of China’s local (A share) market has been a bit disappointing to many investors. However, we still find the market attractive and think there are reasons to be optimistic going forward. We felt an overabundance of IPOs in China’s local Shanghai and Shenzhen (A share) markets in the past few years likely contributed to weak performance in secondary listings during that time frame. In the A-share market, IPOs raised RMB 103.4 billion in 2012, 282.4 billon in 2011 and 491.1 billion in 2010. To put this in context, the total market capitalization of the A-share market was RMB 22.877 trillion in 2012, 21.330 trillion in 2011 and 26.322 trillion in 2010.

Some of these IPOs weren’t receiving the level of review or scrutiny that perhaps they should have, so late last year China’s regulatory body, the CSRC, stepped in and put a halt to new listings. All IPO candidates and their underwriters were asked to complete a self-review and resubmit their 2012 financial reports. The CSRC also stepped up its efforts to prevent fraud, announcing random audits of these companies, which are ongoing. Many IPO candidates subsequently decided to withdraw applications, or put them on hold.

Generally speaking, we think the CSRC’s efforts are headed in the right direction. The latest campaign is aimed at requiring IPO companies to be more accurate in terms of issuing their information so that they give investors a full picture of their businesses. The authorities are holding many investment banks and even auditors personally responsible for the accuracy and assessment of the quality and fundamentals of the companies. The focus is on seeking to ensure high quality and a good business structure for the applicants. The CSRC has also set up new delisting rules, which we view as a positive, the key being in the execution.

As this campaign continues, we think we could see more pending IPOs in the queue fall out. As of March 31, the CSRC said it had received the self-review reports from 610 companies; 107 companies submitted an application to suspend their listing effort as a result of failing to complete the self-review, and 162 submitted an application to terminate. To put those numbers in some context, there were a total of 2,492 domestic-listed companies in China’s securities market at the end of 2012, according to the CSRC. The CSRC is under some pressure because so many companies are on the waiting list, and they want to make sure they are doing a thorough job vetting them. It won’t be easy, and requires a lot of resources.

State-owned enterprises (SOEs) generally have a good paper trail, so it should be easier for auditors and underwriters to track and sign off on them than perhaps other companies. The CSRC’s process therefore could tilt the market toward SOEs, but not because of any bias. If companies dropping out of the IPO process are of good quality and simply suffered a business downtrend last year, they can find other channels for funding, including issuing bonds or listings overseas, or even private equity. The capital market should naturally give higher valuations to companies with better dynamics. The public’s confidence has been somewhat shaken, so we think this process should ultimately strengthen the market and win back investors.

Connecting IPOs and Market Performance

While a new rush of IPOs could cause secondary listings to again suffer, market performance is nearly impossible to predict, particularly when comparing China’s local A-share and overseas H-share markets. While they do diverge at times, we don’t believe one of these markets can consistently and radically outperform the other if they are driven by the same set of economic fundamentals. The A-share market might have outperformed at times this year due to news or rumors (e.g. halting approval of IPOs), but there will likely be periods of both over and under performance in either market.

Within an environment of global quantitative easing, equity markets have generally performed well in recent months, whetting investors’ appetites for more risky assets, or those with historically higher short-term volatility. We cannot predict how long this trend will last, but we expect the market could be volatile given how quickly investor sentiment can shift, even if the long-term outlook for the global and Chinese equity markets remains favorable. Better outlook guidance from corporate management after earning results could provide a bullish catalyst, but we believe China’s equity markets could be vulnerable in the next 3-6 months or so because of the high expectation of a quick recovery in China’s economy, and the high expectation that the government will quickly move forward on reforms following the People’s Congress in March.

However, valuations in many stocks in the A-share market look reasonable to us at this time and, according to our analysis, are trading at a discount to comparable H-share listings, particularly in the banking and the automobile sectors. While we continue to focus on the fundamentals of individual companies and build our portfolio from the ground up, we are currently finding what we think are attractive opportunities in banks, automobiles, healthcare and pharmaceuticals.

China’s Future

We remain confident about China’s prospects and continue to search for long-term investment opportunities there for a number of reasons. It’s our expectation that, as disposable income increases for China’s middle class, more personal assets could be funnelled into savings and investments. Many consumers in China have been benefitting from annual increases in income of 20% or more. In addition, urbanization is continuing, and the government is devoting more resources to infrastructure and subsidized housing as well as extending social security, education and health benefits to new migrants to the cities.

In addition, China’s President, Xi Jingping seems to be laying out a strong reform program with specific timetables and goals. An anti-corruption campaign recently went into full swing, and it seems likely that in some regions, government officials will be required to declare their asset holdings within the next one to two years. The new leaders also aim to increase efficiency of decision making. The implementation of China’s 12th Five-Year Plan should also encourage businesses, calling for a rebalancing of China’s economic growth toward domestic consumption and reforming the financial and social welfare systems. Overall, despite the challenges and volatility, we think the outlook for China’s stock market looks bright.

(For more information on the different equity markets in China, read Mark’s previous post, “The ABCs of China’s Share Markets.”)


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