Chinese Companies on US Exchanges: Is this time different?

The first page of a Google search for “2011 chinese stock” is replete with US media outlets using words such as “worthless,” “scam,” “shocker,” and “fraud.” The following year had no more than three Chinese initial public offerings (IPOs).

Yet it is projected that over twenty Chinese companies will hold their IPOs in 2014 alone. This group includes everything from tech behemoth Alibaba, estimated to be valued around the $16 billion USD that Facebook raised in 2012, to Weibo, the popular microblog platform that just listed at $285 million.

The first part of this piece provides a broad history of Chinese companies’ US listings, contextualizing this year’s abnormally large lineup.

The second half profiles this year’s lineup of listed companies and expounds on the still-tenuous relationship between US investors and Chinese companies in order to explain the present situation.

PART I

From the beginning, Chinese companies have largely maintained an image congruent with American perceptions of the country while listed on US exchanges.

Thanks to Deng Xiaoping’s institution of the Open Door Policy, Chinese companies were first listed on the NYSE and NASDAQ in the mid-90s. With the economy “opening up,” state owned enterprises (SOEs), responsible for nearly 80 percent of industrial output in the years prior, were sold as infrastructural and manufacturing plays.

As China developed and its international presence grew, the turn of the century saw the introduction of higher-profile listings in telecommunications and oil, bringing in bigger SOE plays such as China Unicom and PetroChina.

At the time, China’s astonishing growth in GDP and economic potential enchanted American investors. They sought after stocks in these companies as strategic growth plays while largely disregarding fundamental analysis. This strategy proved imprudent: From 2000 to 2003, these stocks performed poorly. Most notably, the once-popular China Unicom plummeted nearly 75 percent. Renaissance Capital, an IPO research group, reports that many of these companies failed to rise because they were not managed as developed markets demanded, with roughly estimated financials and shady management. Meanwhile, the dot-com bubble overheated American markets, and these two factors influenced the 2002-03 dips in Chinese listings. American investors were hesitant to invest, and Chinese companies recognized it.

However, 2004 ushered in what China Economic Quarterly dubbed “The Year of the Chinese IPO.” Some motivating factors were the $3.5 billion IPO of insurance company China Life in December of 2003, Warren Buffett’s 2003 investment in PetroChina, and China Mobile’s announcement of a twenty percent maiden dividend for investors.

Besides, this batch of IPOs was markedly different from the last. The stocks were sexier: reflections of a new and mature China, with opportunities in a burgeoning service-sector economy instead of industrial SOE plays. Characteristic examples were Suntech, a solar-panel producer; Longtop, a financial software company; and New Oriental, China’s Princeton Review equivalent in English-language education.

From 2004-07 American investors remained interested, and Chinese companies comprised a record five percent of all US-listed IPOs (eight to nine per year).

Things were looking up until the Chinese stock bubble popped in 2007. Precipitated in part by rumors that the government would be hiking interest rates or instituting a capital gains tax, the Shanghai Stock Exchange dropped a whopping nine percent.

Yet American investors remained unfazed: By 2009, Chinese companies had bounced back. In fact, through the depths of the recession, while American companies suffered cutbacks, Chinese listings skyrocketed and comprised an average 20 percent of total listings on American exchanges, and 2010 saw an unprecedented thirty-five plus IPOs. As Internet penetration and smartphone usage rose in China with urban migration and the middle class’s emergence, e-commerce and video-sharing platforms grew attractive. 2010 saw the IPO of companies such as Youku, the Chinese equivalent to YouTube, and ChinaCache, a digital content delivery network (CDN).

Through 2011, US investors ignored the questionable financial statements and suspicious management backgrounds of numerous Chinese companies going to market. It was accepted that, for example, the companies would hire English-speaking CFOs only immediately before listing to better appeal to their investors.

In mid-2011, though, the façade of legitimacy was shattered.

That March, a lesser-known television advertising company, China Media Express, mysteriously announced the resignation of its auditor (Deloitte) as well as its CFO and public relations firm. An ensuing SEC investigation uncovered fraudulent accounting, but there was no market response: investors believed it was anomalous.

Two months later, perhaps motivated by the China Media Express scandal, Deloitte asked bank headquarters to verify the financial statements of Longtop, a client of six years, instead of the local branches it had worked with hitherto.

The Big Four auditors (Deloitte, KPMG, PricewaterhouseCoopers, Ernst & Young) had been responsible for working with most of the Chinese companies listed on US exchanges. Traditionally, the auditors had accepted branch confirmations of client statements. The Longtop case was the first time that Deloitte had gone straight to HQ.

Longtop’s management, guilty of fraudulent accounting, panicked. The COO and company claimed the Deloitte representatives were imposters, demanding the bank seize all auditing documents.

Several days later, Longtop’s chairman admitted to Deloitte the presence of “fake cash recorded on the books,” and Deloitte resigned immediately. The scandal garnered substantial media attention, especially since Deloitte had audited Longtop for the past six years without any issues.

China Media Express and Longtop were just the tip of the iceberg. At least nine others had similarly deceived auditors, and the government-run banking system had been complicit throughout. Before soon, Chinese companies were rushing to cancel filed IPOs in the face of overwhelmingly negative investor sentiment.

It should be noted that institutional investors had also been duped: Starr International invested $43.5 million in China Media Express, and Goldman Sach’s Investment Management team bought a 7.6 percent stake in similarly fraudulent additive manufacturer Shengda Tech. Just about everyone (except, perhaps unsurprisingly, the sage Warren Buffett) had been played.

In June, Renaissance Capital noted that the average return on US listed Chinese IPOs from 2008-11 was a whopping -23.5 percent (all other IPOs returned an average of 24.8 percent), emphasizing how poor the investments actually were. By then, most stockholders had tried liquidating.

In America, stocks in the Chinese companies were regarded as worthless investments. For each investor that lost money, countless more lost faith. Meanwhile, Mitt Romney was condemning China’s currency manipulation while the US presidential elections vilified one of the recessions’ scapegoats, China. The public’s concern for China as a growing power also negatively influenced investor sentiments, which fell to a historic low.

Whether SOEs in the mid-90s or tech stocks in the past decade, Chinese listings were first well received on US exchanges as sexy growth stocks, mirroring American perceptions of the country’s economy. But, the major falling-out in 2011 exposed a corrupt financial system, stripping the Chinese companies of any credibility and, accordingly, their US-listed IPOs ebbed in the following two years.

PART II

How can the recentness of such a traumatic experience be reconciled with this year’s abundant lineup? China Daily, the Chinese Communist Party’s (CCP) English-language mouthpiece asks if this is the season of the Chinese IPO. Certainly it is; this is a remarkable number of IPOs.

But the more important question is: Why? What environment is enabling this resurgence?

When planning their IPOs, Chinese companies no doubt predicted positive investor sentiment. Riding off of the S&P soaring 29.6 percent, the highest in sixteen years, investors have been exuberant. Moreover, the Chinese 3rd Plenum from last winter and People’s Congress of this past March both communicated future market liberalization, similarly exciting international investors.

Additionally, technology is hot in American markets. Amazon and Google are trading at record highs, and the IPOs of Facebook and Twitter have further encouraged American investors to consider Chinese microblog platforms (Weibo) and the various e-Commerce (JD.com, Leju, and of course, Alibaba) offers.

The US media’s constant coverage has also been a supporting force, reminding investors that Alibaba’s IPO will impact the American economy. Forbes’ Peter Cohan writes that Alibaba may pose a threat to Amazon upon its arrival. Yahoo!’s 24 percent stake in Alibaba will enable it to make numerous new acquisitions. The tangible consequences and sheer potential of Alibaba’s roughly $16 billion listing have kept American investors’ attention.

Still, it is dangerous to assume that Alibaba is marking a watershed moment for Chinese stocks. These companies may be merely capitalizing on an advantageous environment.

Many of the Chinese companies have listed in the US because of the end of a fourteen-month Chinese  moratoriumon domestic IPOs that created a dreadfully long waitlist. Whereas Alibaba has garnered most of the attention, offering in America was a backup plan followed once the HKSE refused to allow management control over the company. It easily follows that the small and medium cap companies, which comprise the majority of this year’s lineup, are simply riding the excitement evoked by Alibaba in an already hot American market.

These companies may also see 2014 as their last chance to IPO. They may foresee either recession or strict regulation in the future, both domestically and abroad. Even with briefly waning investor excitement, Weibo settled for a measly $285 billion IPO (originally planned at $600 billion). If they have no plan B, these companies will continue to accept conservative listing prices.

Remember, these investments are not infallible. There is no proof that these companies have trustworthy accounting practices or are competitive alternatives to American stocks.

Some of the auditors got off scot-free, blaming the government-owned banks in China for their mistakes, but the banking system remains opaque. It is of no assistance that the Chinese government is currently using secrecy laws to refuse the SEC access to auditing files used by the Big Four in China. Worse yet, the SEC banned the Big Four’s China affiliates (responsible for companies such as Alibaba) this January. In case of auditing emergencies, this impasse will further complicate matters.

Finally, Chinese stocks have yet to prove themselves. Barron’s used a portfolio of US-listed Chinese companies that trailed the S&P by ten percent over the past year. Over the past five years, while the S&P grew almost 150 percent, the aforementioned portfolio grew less than 60 percent. Plain and simple: most of the Chinese stocks do not compete well. The market may be overlooking these stocks’ intrinsic value, but that is because said value is near impossible to ascertain. Besides, shorting in real estate and banking has risen in popularity on HK exchanges, implying volatility in Chinese domestic markets that could adversely affect companies across the board.

As we learned in 2011, investor optimism in no way legitimizes investment. It appears this year’s group is taking advantage of favorable IPO conditions, but it remains to be seen whether their stocks will rise or flop. Much of this rides on Alibaba’s performance, individual companies’ finances, and investor sentiment, none of which is set in stone.

University of Florida