The big dipper

On September 16, 2008, many of the daily newspapers in the US looked like clones. The headline story, obviously, was the collapse of Lehman Brothers. But what made the front pages appear similar was that fact that many of them had used the same photo of Elizabeth Rose, a trader working on the floor of the New York Stock Exchange, who was covering her eyes. It was an image that neatly conveyed shock and despair after a turbulent trading session.

Newsstands in Hong Kong on Thursday elicited a very similar crisis mood. All the newspapers picked up on an identical story, and also used very similar photos. This time it was about the city’s slumping stock market. “The day when the only way was down,” the South China Morning Post’s headline read. “Stock market crisis in Hong Kong and China,” Singtao Daily proclaimed, with a sub-heading reminding investors that the key index’s 2,138-point intraday dive was “the worst in history”. The Hong Kong Standard went with the headline “$1.4 trillion vaporised”, doing so in a supersized font.

A frenetic sell-off in Chinese stocks continued in the early part of this week, bucking a battery of support measures from Beijing. By Wednesday the panic finally spilled over to Hong Kong, which by default had become the most viable outlet to sell.

That’s because investors could no longer sell a lot of stocks across the border. More than 1,400 of the listed firms in China were suspended from trading at one point this week. They collectively asked for their stock to be suspended to protect their market value amid the rout. They were untradeable as a result.

This pushed short-sellers to switch their focus to the Hong Kong exchange, given that most state giants are dual-listed there as well as in Shanghai. “If you can’t sell the orange in Shanghai, why not sell a tangerine in Hong Kong?” a financial blogger said.

As of Thursday, the benchmark Shanghai Composite Index was down nearly 40% from June 12, its seven-year peak. The Shenzhen Composite Index, which reflects the price movements of some of the country’s high-flying tech stocks, plunged by nearly half during the same period.

Yet the Chinese bourse which has suffered the worst reversal is neither in Shanghai nor Shenzhen. It is the Beijing-based National Equities Exchange and Quotations (NEEQ), an over-the-counter market similar to America’s OTC Bulletin Board.

In fact, the correction in this more risky and less liquid market began much earlier. According to 21CN Business Herald, the NEEQ Market Making Index peaked on April 7 at 2,673 points. Since then the index has slumped nearly 60%. On Tuesday alone it dropped 12%, its 10th consecutive retreat. “Different government departments have been busy trying to save the A-share markets, but the New Third Board has been forgotten,” noted 21CN.

Things were much rosier a couple of months ago. NEEQ’s rise over the past year and a half had been phenomenal, even by Chinese standards.

The board was founded in 2006, as a pilot project to trade the shares of companies based in Beijing’s Zhongguancun Science Park. In 2012, its remit was extended to science parks in Shanghai, Wuhan and Tianjin. Then in December 2013, the State Council announced that any joint stock company that wished to transfer its shares onto the board could do so.

“Companies on the new third board represent the direction of China’s economic transformation. Two years ago the State Council identified seven big strategic emerging industries. The new third board is a chance to invest in these trends,” Fu Bairui, a local fund manager, told the Financial Times earlier this year.

Importantly, the approval process to list on NEEQ is simpler than the cumbersome and oft-criticised regime used by the China Securities Regulatory Commission when it vets companies seeking to IPO on the main exchanges.

Companies don’t need to show a record of profitable performance, unlike those wanting to debut on Shenzhen’s ChiNext (China’s closest equivalent to Nasdaq) or the same city’s SME Board (which targets manufacturers).

Trading on NEEQ is conducted through market makers or via a negotiated transfer between two independent third parties, who then register the trade via the exchange’s quotation system.

Unsurprisingly the numbers of listed entities on the board quickly exploded. Before the State Council’s ruling 355 companies had a NEEQ listing (all sourced from the science parks). A first batch of new firms was added in January 2014, and by the end of last year the number was up to 1,572. As of last month it stood at 2,547, almost eclipsing all of the other exchanges put together.

(The Shanghai Stock Exchange has 1,058 listed firms, while 480 are listed on Shenzhen Stock Exchange’s Main Board, 767 on the Shenzhen SME Board and 480 on ChiNext.)

NEEQ-listed firms are smaller, so its market capitalisation and trading volumes are much lower than its peers. China Economic Weekly reports that turnover amounted to just Rmb88.48 billion ($14.26 billion) between January and May. With the exception of ChiNext, China’s other exchanges record higher volumes than this on a daily basis. In May, for instance, Shanghai was averaging Rmb1.56 trillion a day.

As investors piled into ‘concept’ stocks, the amount of speculative trading on NEEQ inevitably increased. Tianxing Capital has invested heavily in companies listed on NEEQ and even before the carnage of the past few weeks, its managing partner Suzie Wu was expressing concern that “too much expectation will ruin the board before it matures”.

This was not part of the government’s plan. The goal for NEEQ was to open up new financing channels for small companies as part of a broader push to move the economy away from state-bank lending and excess debt financing.

Unfortunately Tianxing Capital’s chairman Liu Yan tells Southern Weekly that the competition to invest in promising NEEQ listed start-up companies became too intense. “The fast fish will always eat the slow fish,” he explains, saying that his firm gave up on investment opportunities due to the frenzied atmosphere of the past six months of trading. Investments in higher-risk companies were also being made with much less due diligence than during the era in which NEEQ was a platform for channelling funds into science parks.

At 64.2% of the total, the majority of NEEQ-listed companies are tech start-ups. The board also has a number of financial firms including JD Capital and Xiangcai Securities (its most profitable company, with net earnings of Rmb798 million in 2014). As China Economic Weekly says, the exchange has also tried to “let 100 flowers bloom” in the real economy, with the admission of firms such as fermented bean curd manufacturer Zhulaoliu and spicy chicken feet vendor YouYou Foods.

Valuation multiples on NEEQ, while still toppy, have tended to be lower than on other exchanges. The average historical price-to-earnings ratio was 52.31 times at the end of May, according to China Economic Weekly, which was a lot lower than ChiNext average of 107 times at the end of June (notwithstanding a 30% fall over the course of the month).

As these companies became larger and more profitable, the idea was to transition them to ChiNext or Shenzhen’s SME Board. However, Southern Weekly reports that some companies have been so content with their experience on NEEQ that they haven’t been pushing for a transfer to ChiNext. On June 17, the State Council decided to give them a nudge with the publication of new guidelines designed to improve IPO access across China’s stock exchanges, while the Shanghai Stock Exchange said it will launch a new board called the Strategic Emerging Industries Board targeting IT, renewable energy and biotech firms that have passed the start-up stage. Market regulators also announced that they are examining how to open up ChiNext to unprofitable firms that want to list directly, as well as those that have taken the NEEQ route first.

Of course, these announcements were made before the market turmoil of the past three weeks. Further reforms to the listing process – while usually regarded by analysts as welcome – will likely be mothballed until a calmer mood returns. NEEQ’s allure seems set to diminish with investors too, especially as the prospects for its companies to relist on China’s larger exchanges at higher multiples look less plausible.

All told, it could be a fraught summer for NEEQ. With market confidence badly dented, the speculative froth that drove many of its stocks will now be revealed.

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