Investment Adventures in Emerging Markets

China’s Frozen IPO Market Thaws

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The year of the horse is upon us! Whether China’s market will experience a wild ride or a gentle trot this year remains to be seen, but my team and I are excited about the many changes taking place there. Financial market reform has been on the agenda in China and, after a long period of hibernation, initial public offerings (IPOs) finally emerged back into the market following a 14-month deep freeze. I’ve invited my colleague Eddie Chow to talk about what this development means for investors and to share his general outlook for China in the year ahead.

I have high hopes for China’s equity market in the New Year, the year of the horse. The horse is a very intelligent animal. It is energetic, likes to compete and, once trained, can be an invaluable, helpful partner to people. It also signifies nobility and success. China’s market has been through some ups and downs over the past few years. This year, we see reasons for us to stay positive, but, at the same time, there are also risks that we need to watch. The Third Plenary Session of the 18th Communist Party of China last year resulted in the unveiling of a reform blueprint, and we should see more detailed plans and concrete measures to follow outlining how these reforms will be implemented. I would expect industries including financial, healthcare and infrastructure will likely be deregulated and allow for greater private capital participation.

Eddie-Chow1

Eddie Chow
Executive Vice President/Managing Director
Templeton Emerging Markets Group

Economic recoveries in the developed markets seem to be gaining greater momentum, which we also believe should be another positive factor for China’s market. Greater growth in these countries should help revive China’s exports and support its overall economy. On the fiscal side, we anticipate that the Chinese government is also likely to maintain a slightly loose policy, moderately increasing government spending in social infrastructure to stimulate the economy. Risks include possible investor outflows from emerging markets generally—as the US Federal Reserve (Fed) continues to taper its longstanding asset purchase program, the need to wind down activities of polluting industries, and even default of trust products as it relates to restructuring of local government financing. These issues could all require our close attention.

A New Landscape for New Listings in China

Since October 2012, new listings had been halted in China’s domestic (A-share) market, but a few new IPOs were allowed to trickle into the market late in 2013. More listings are expected this year. In general, the re-opening of China’s IPO market is a positive move, as the stock market is one very important channel for businesses to raise fresh capital. Its role in facilitating the flow of savings to investments cannot be stopped forever. We should also cheer the fact that the China Securities Regulatory Commission (CSRC) has introduced several new policies to regulate and improve the IPO process. We had expected that the IPO market could likely have stayed frozen for even longer than it has, and the resumption could be positive for securities companies that have sizable investment banking business. However, we think overall valuations of those companies have been high and are not that attractive to us at this time. We may, however, need to watch the shorter-term supply and demand situation in the market more closely. If there is a lot of new supply as new companies are listed on the market, valuations of companies in the same or similar industries could be dampened.

Initially, the new listings will likely cause some investor excitement. Investors may perceive the 700 – 800 companies now in the IPO queue to be of better quality after rounds and rounds of CSRC review and greater efforts on the part of the issuers and investment banks to improve transparency. Some may worry that this will stifle the interest in the secondary market, which we have seen happen during past IPO booms. However, I would think the newly listed companies would be welcome additions to the market, as they provide more opportunities for investors. And, with clearer requirements on follow-on sales in the secondary market by major shareholders, especially for those that go below IPO prices, small investors’ interests seem to be better addressed. In terms of asset flows, I don’t anticipate there will be a big dilution in the secondary market. The government has encouraged greater participation from institutional investors and pensions in the equity market, and they are further given greater incentives to participate in the IPO market. This is, in general, positive for the development of the overall market over the long term, in our view. The IPO thaw can also rejuvenate the private equity (PE) market, as PE investors now have a clearer picture of the IPO framework and how deals can be structured. This is important to the development of the private sector of the economy. Over the last few years, A-share IPO pricing was criticized by secondary market investors because the valuations of IPOs were too high, and it affected the future stock returns after listing. But with the reforms initiated by CSRC recently, the new system will adopt a quasi-auction system to determine listing prices, and it also grants the underwriters and issuers greater say in the allocation. As a result, we believe future IPO pricing is likely to come down to a more reasonable level and secondary market returns could improve.

Restoring Investor Confidence in China

The CSRC has taken a very important step in helping to restore some of the confidence that has been lost in China’s domestic market in the past couple years, changing the IPO system from one that is approval-based to one that is registration-based. And, at the same time, the CSRC demands greater transparency in information disclosure and imposes greater restrictions on major shareholder share sales. We think the rules are now better written, but the key is still on enforcement, which is more important in regaining investors’ confidence. In our view, the CSRC should also look into other market irregularities such as insider trading and/or market price manipulation. On the fundamental side, state-owned enterprise (SOE) reform and probably redesigning the compensation system of SOE managers—with the aim of better representing the minorities’ interests—should also help to restore confidence.

At this time, particularly given recent market volatility, I think China overall can present a good value to investors. Some areas or themes we are excited about right now in the market include consumer-oriented companies producing both discretionary and staple products as well as health care. Taking a long-term view, we believe China should exhibit some of the best characteristics of the horse: strength, endurance and spirit.

Dr. Mobius’ comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or a recommendation to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. This material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

All investments involve risks, including possible loss of principal. Foreign securities involve special risks, including currency fluctuations and economic and political uncertainties. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets.

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