Casino culture

March 13, 1986 was a seminal day for the Nasdaq stock exchange. Anyone who took the opportunity to buy into a company called Microsoft was about to see what a market for ‘growth’ stocks was all about.

Those who purchased a single share in the US software maker at IPO (for $21) would be sitting on a position worth $7,762 today. In other words, an investment that has grown 370 times.

Access to Nasdaq’s pool of risk tolerant capital, in turn, enabled Microsoft to grow into a global powerhouse. With its mission to list growth firms, Nasdaq helped transform many promising-but-barely-profitable concerns into industry leaders. Oftentimes those firms have even created ‘new’ industries. Companies like Google were to follow Microsoft’s example.

China’s policymakers last year decided they wanted to copy the model. Accordingly, the ChiNext exchange was established in Shenzhen. Its mission: to IPO ‘growth’ companies that weren’t able to meet the listing requirements of Shanghai’s A-share market.

The hope was to use China’s own ‘Nasdaq’ to promote a new generation of innovative companies in areas like eco-friendly energy (and likewise to reward with supercharged returns the gutsy local investors prepared to back them).

October 30 was ChiNext’s first birthday, a milestone that has led the nation’s media to ask whether that mission has been accomplished.

So has ChiNext been a success?

At the launch ceremony last October the theme tune to the movie Superman was played. For the sceptics, it was a little hubristic. But it did at least have the advantage of allowing them to ask: is it a bird, a plane or just a casino?

With China awash in stimulus plan liquidity, the suspicion was that ChiNext could become yet another channel for speculation. In WiC’s Talking Point in issue 36 our headline was “A new place to punt?”

The first day of trading only seemed to confirm as much.

All 28 firms that debuted that day saw their stocks suspended within two hours, having soared 80% and breached the exchange’s inter-day limits. When they were allowed to start trading again in the last three minutes of the session, they ended up an average of 110%, with one stock gaining as much as 210%.

According to the Shanghai Securities News, a total of 252,600 retail investors bought a combined 423 million shares that day. Little wonder the People’s Daily thought that exuberant investors “chose to gamble big”.

And one year on?

The exchange has certainly seen phenomenal growth. According to Wind, a Shanghai-based consultancy, 127 companies have now tapped ChiNext, raising a combined Rmb93.12 billion ($13.94 billion).

However, many in the local media question whether ChiNext really has been a success. Take CBN Weekly, which in a recent article noted that investors have “ridiculed” it as “the garbage board”. The magazine reports that when the first firms listed a year ago it was “a grand occasion hardly to be forgotten, but one year on ChiNext seems so bleak.” The rationale for the pessimism? At launch, ChiNext hyped its desire to list companies that conformed to what was termed as the ‘two highs, and six news’. That dictated that IPO candidates should be ‘high growth, high technology’ firms from six sectors: new economy, new agriculture, new services, new energy, new materials or have a new business model.

CBN Weekly points out that while many of the firms that listed sold themselves to investors on the basis of their high margins, high revenue growth and high returns on equity, the reality has often proven to be somewhat different. “After listing, the profitability of ChiNext companies is showing a big reversal,” it states.

According to Wind’s data, ChiNext firms had grown their year-on-year net profits by 45.6% in 2009 i.e. the year of their listing. But by the first half of this year (i.e. immediately after listing) these so-called ‘high-growth’ companies had seen that number slip to 25.5%. Century Weekly says that is “far below” some of the comparable growth numbers for the A-share market – even though it is populated with supposedly bigger, more mature firms.

Worse, points out CBN Weekly, is that in the first half of this year 12 firms saw their profits decline by 20% or more. The worst performers were Bode Energy Equipment, AVCON and Narada which saw their net profits decline by 82.07%, 76.60% and 69.79% respectively.

Growth capital…

Of course, high growth companies often claim profits will grow in future. The immediate goal is to grow revenues, customer bases and market shares. But once again, Wind’s statistics tell an interesting story on how much of the IPO proceeds have been spent.

Companies evidently raised a lot more than they could invest in their core businesses. Wind reckons the 127 ChiNext-listed firms came to market with plans to invest a collective Rmb45.55 billion, but have actually invested just Rmb8.72 billion.

For example, Bode (the firm that saw the greatest decline in profit) seems to have banked its IPO proceeds. It derived 34% of its first half income from the interest it got on its bank deposits. That’s odd: high growth firms are normally hungry to invest new capital rather than bank it. Think Facebook, and the speed with which every dollar invested was spent on new servers.

Then again, Bode’s somewhat conservative approach looks less egregious than others. China’s media suspect that other firms used part of their own IPO proceeds to speculate in the property market. Again, not something you can imagine cropping up in any of Mark Zuckerberg’s planning sessions for Facebook either.

All of the above helps to explain why ChiNext’s performance has been more lacklustre in recent times. After its initial surge, investors have cooled on its fundamentals, as well as the types of companies that got tickers. Bloomberg last week reported that an index of 100 ChiNext firms has gained only 6.7% since it was introduced on June 1. Meanwhile the Shanghai Composite Index is up 17%.

Other reasons for underperformance?

One major issue that has investors worried is a nasty stock overhang. As of Monday about Rmb33 billion of ChiNext shares suddenly became tradable because one year shareholder lock-up periods had expired. The South China Morning Post reported that Rmb530 million of stock was sold on the first two days of this week – the sell-off impacting the 27 firms for which the lock-up had ended.

The sales were a sign that founders were cashing out, Shanghai Securities analyst Wang Fen said, dealing a “psychological blow”.

In fact, 50 general managers, board members and CFOs at 37 ChiNext firms have already resigned – a move that hastens their ability to offload their stock. Of course, when insiders want to sell, it often suggests shares are already overvalued. As of Wednesday, firms listed on ChiNext were trading at more than 72 times 2009 earnings – so the temptation to cash out and make a quick buck is big. Further dampening the mood: the continued absence of a mechanism to delist the weakest players. This was promised when ChiNext launched, the idea being to foster good behaviour. But, one year on, no plan has been unveiled, indicating that quality-control is going to prove a problem for the nascent market.

So is there a Microsoft-like stock currently on the ChiNext: a potential game-changing, industry leader likely to reward investors by multiplying their money a hundredfold?

WiC can only speculate. But we do know from first-hand knowledge that when we asked the CFO of one of China’s most promising privately-held tech firms whether it would list on ChiNext, the answer was an immediate negative.

Guess where it wants to list instead? That’s right. On Nasdaq. (As will Tudou, see page 11). This begs the question: can ChiNext attract the best of breed? Or will it, as local media fear, just prove a casino of sorts?

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