Investors sit in front of an electronic stock board at a securities brokerage in Shanghai, China. (Photographer: Qilai Shen/Bloomberg)

World's Most Predictable Stock Trade Faces a China Reckoning

(Bloomberg) -- In China’s volatile equity market, at least one thing’s been a certainty: initial public offerings price low and then rally like crazy.

An unwritten valuation cap, imposed by the regulator, means listings all debut at about 23 times earnings or less. Entrepreneurs have had no choice but to pocket an artificially low amount and then watch their shares soar by the daily limit, over and over again.

But this defining -- and distorting -- characteristic of the $7.3 trillion market may be about to change, at least for some companies. Analysts say firms selling the first-ever Chinese depositary receipts won’t be subject to the valuation restriction. Xiaomi Corp. is planning to raise $5 billion, or half of its total offering, from the new type of security that’s a high-profile attempt by Chinese officials to lure big tech firms back home.

“They’ve got to relax the valuation caps otherwise CDRs won’t work,” said Ken Wong, a Hong Kong-based fund manager at Eastspring Investments, which manages about $170 billion. “You can’t have these restrictive rules if you want to attract the biggest names in tech. It’s a step in the right direction.”

Click to read more about Xiaomi’s potential valuation

The China Securities Regulatory Commission didn’t immediately respond to a faxed request for comment on whether companies issuing CDRs will have more flexibility in pricing.

Authorities published the final rules for their trial program this month, less than three months after the CDR plan was first publicly announced. The urgency signals China’s desire to get its most innovative firms represented in its domestic equity market, which is clogged with state-controlled dinosaurs even though China has produced some of the world’s biggest tech businesses.

Though mainland retail investors have been able to buy shares of Hong Kong-listed firms like Tencent Holdings Ltd. through an exchange link with Shanghai since 2014, it’s much more difficult for them to trade stocks in the U.S. That’s where locally-cultivated technology stars like Alibaba Group Holding Ltd., Baidu Inc. or NetEase Inc. have opted to list.

Those decisions were at least in part because of China’s rules for IPOs, which also include a ban on dual-class structures and an approval process that’s spawned a 300-plus backlog of wannabe listings. They were designed to protect individuals from buying into suspect companies at inflated prices.

In practice, the chokehold on supply and pricing, as well as the implicit government endorsement, created an investment on which it’s impossible to lose. In 2018, all 49 new listings soared by the 44 percent limit on the first day of trading, and many kept surging for weeks after that.

Read more about China’s IPO market dynamics here

With CDRs, China’s trying to do it differently. Officials have approved six mutual funds that may raise almost $50 billion to purchase the securities, locking in cornerstone investors for three years and making it more difficult for punters to flip the stock. The regulator has said it “hopes” that the market won’t engage in speculation, and the government says it won’t guarantee returns or the quality of candidates.

Firms that opt to bypass retail investors altogether and sell shares exclusively to institutions and high-net-worth individuals will enjoy a simpler and speedier approval, effectively allowing sophisticated investors to take on a greater role in the pricing process, according to Goldman Sachs Group Inc.

After Xiaomi’s debut, China’s restaurant review and delivery giant Meituan Dianping -- which plans to file for an IPO of about $6 billion in Hong Kong as soon as this month -- is considered a prime candidate to sell shares on the mainland.

Higher Valuations

The CDR trial “can also be seen as a key reform measure of introducing global best practices to the local market, notably the new IPO approval process and pricing mechanism,” analysts at Goldman including Kinger Lau wrote in a note this week.

Morgan Stanley says CDR valuations may be higher than those of their underlying stocks in New York or Hong Kong because mainland investors have few alternatives if they want a slice of a global tech champion. The sector, which makes up about 40 percent of the MSCI China gauge tracking offshore shares, is about 10 percent of a measure tracking A shares. Alibaba trades at about 30 times forward earnings.

“Tech stocks have historically been more expensive onshore and they represent scarce assets in that market,” Morgan Stanley equity strategist Laura Wang said by phone from Hong Kong. “But there’s still so much more information that needs to be disclosed on the technical, regulatory and trading side for us to really understand the scale of that gap.”

©2018 Bloomberg L.P.

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