Chinese stocks that trade in the US have always been a double-edged sword for investors, but Americans now face a wicked blade as years of buildup leads to an inevitable end.
After hundreds of sketchy offerings on US markets for young China-based companies with huge potential for either growth or complete collapse, the market in these stocks fell apart in 2021.
“Valuations have declined sharply. There have been no IPOs in the last few months. And there have been a number of going-private transactions,” said Jesse Fried, a professor at Harvard Law School.
Matthew Kennedy, a senior strategist with Renaissance Capital, an IPO research firm that also has two IPO-focused ETFs, said there were 30 China-based IPOs on US exchanges in the first half of 2021 and only four in the second half, before the window shut. This year, he said 34 Chinese companies raised $12.6 billion by going public in the US, up from 30 deals in 2020 that raised $11.7 billion, excluding SPACs (special- purpose acquisition corporations).
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But the results for the US investors who bought those stocks have not been as rosy.
“Even if the Chinese government and the US government gave these companies the green light, the average return for [Chinese based] 2021 US IPOs is negative-42%. Only 12% are trading positive,” he pointed out.
It isn’t just the rookies who have suffered. In May, according to the US-China Economic and Security Review Commission, there were 248 Chinese companies listed on US exchanges with a total market cap of $2.1 trillion. That value has fallen sharply, to approximately $1.5 trillion, lopping off $600 billion.
The decline has left many American investors holding on to Chinese stocks with hopes that they will rebound, or as potential losses to offset other taxable gains if they are sold in 2021. But with a new US law requiring more disclosures from the auditors of Chinese companies, combined with pressure from Chinese regulators on companies with a lot of data to list in China instead, it appears the market for Chinese stocks in the US has blown up, and more pain may be on the way.
“China doesn’t own these securities, US investors do,” said Brendan Ahern, chief investment officer at Krane Funds Advisors, LLC, which has a suite of China-focused ETFs. “That savings is at risk.”
Didi delisting is an example of what is to come
An example of what could be on the way for the dozens of Chinese companies still listed on US markets is Didi Global Inc. China’s version of Uber was the largest initial public offering of the year in the US, but fell apart just days after listing, and is now delisting from the New York Stock Exchange and headed for Hong Kong.
Didi was at odds with the Chinese government from the get-go when it went public in June. In July, The Wall Street Journal reported that Chinese regulators had warned Didi not to go public in the US because it believed that the ride-sharing app company had too much data that made it a security risk. At its peak after raising more than $4 billion from investors in its IPO, Didi had a market cap of about $80 billion. Its market cap is now around $29 billion.
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The delisting of Didi in the US is an example of what could happen with many other China-based companies whose shares trade in the US as a new law, the Holding Foreign Companies Accountable Act, or HFCAA, is set to go into motion. Signed into law in December 2020, the HFCAA states that any foreign company that trades on US exchanges must submit to inspections of their auditor’s work books by the Public Company Accounting Oversight Board. If they don’t, they will be delisted after three consecutive years of noncompliance, with this December marking the first year since the law passed.
Last month, the Securities and Exchange Commission finalized the rules that will require foreign companies give the PCAOB the documents, or so called work books, used in overseas financial audits. In addition, companies must provide proof that they are not controlled by their governments. Many Chinese companies have board members with ties to the Chinese Communist Party or to the Chinese military.
“Everyone knew this was coming so this wasn’t a surprise,” said Shaswat Das, counsel with King & Spalding in Washington and chief negotiator for the PCAOB with Chinese regulators from 2011 to 2015. “The SEC finalized the rules implementing the HFCAA, and the PCOAB has determined already that China and Hong Kong are noncooperative jurisdictions, so it looks like this is going forward.”
In mid-December, the China Securities Regulatory Commission, or CSRC, said it was in talks with US regulators regarding cooperation over the auditing of US-listed Chinese firms, and that it was making progress.
“The CSRC, China’s version of the SEC, put out some interesting comments,” said Ahern of Krane Funds. “My read is they would like to solve this issue, they continue to engage the SEC and the PCAOB. There might be some more dialogue or communications between the two sides.”
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“It’s like a tug of war between US regulators and the Chinese,” said Paul Zarowin, a professor of accounting at New York University’s Stern School of Business. “The CCP and [Chinese president] Xi Jinping are trying to get more control over everything.”
Harvard’s Fried said that despite the recent comments, he remains skeptical that leaders will allow China-based auditors to be inspected by the PCAOB, citing what happened with Didi as an example.
“If they are this paranoid about sensitive info falling into the hands of Americans because the companies are listed in the US, it seems unlikely China will let the PCAOB into the country to inspect audits,” Fried said. “And that means the endgame under the HFCAA will be the forced delisting of these companies, even if China does not force them to come home.”
Moving to Hong Kong is best possible outcome
That leaves American investors stuck, waiting to see what will happen, especially with popular stocks such as Alibaba Group Holding Inc.
“At this point we are in a wait-and-see mode, to see how it works out,” said Dan Morgan, a senior portfolio manager at Synovus Trust Company, which owned about 30,000 shares of Alibaba as of early November.
As they wait, their investments have already been tremendously devalued by a market expecting ongoing turmoil and potential delistings. Alibaba has lost roughly half of its valuation in 2021, while the Invesco Golden Dragon ETF is down about 47% year to date and the KraneShares SCI China Internet ETF is down around 51% year to date, with most of those declines coming after this column warned against holding China-based stocks last summer.
But Alibaba has already seemingly prepared for possibly delisting from US markets. In November 2019, Alibaba shares began trading on the Hong Kong stock exchange as a secondary listing, where it raised an additional $11 billion in capital. That was five years after its initial IPO in the US.
For investors holding the big-cap Chinese stocks, a move to the Hong Kong stock exchange is the most straightforward and the best possible outcome. That would include some of the biggest US IPOs of the last two years, like e-commerce company Pinduodou Inc., which has a US market cap of $68.6 billion and electric-car maker Nio Inc., with a $46.1 billion US market cap.
“A large share of US companies subject to delisting already have secondary listings in Chinese markets,” said Andy Rothman, an investment strategist at Matthews Asia, the the largest dedicated Asia investment specialist in the US. But he added that the looming situation is an example of why investors who want to get in on China’s growth should work with professionals, because institutional investors have an easier conversion of American depository receipts (ADRs) to other exchanges.
“If an institutional investor owns the ADRs in the US, say using Alibaba as an example, it is only an administrative paperwork process to convert those shares; it’s not a taxable transaction, you don’t have to make a market in it,” Rothman said.
Rothman said China is an enormous market that is impossible to ignore, but that it is a complicated and difficult market to understand.
“But this is why Matthews was set up about three decades ago…it requires a lot of stock picking and due diligence because it is a hard market to crack. There have been a couple of fraud cases, but it would be a mistake for investors to turn their back on that market simply because of that.”
Adding that he was “selling his own book,” Rothman noted that the fund managers at Matthews don’t take at face value any of the numbers that come out of China. “We want to do our own due diligence to make sure we are comfortable with the numbers and the management,” he said.
Individual investors may be left out
The delisting process, as this column has said before, will hurt the retail and individual investors the most, if they are not prepared. Companies that haven’t established a dual listing and don’t meet the requirements to move their shares to the Hong Kong stock exchange will be the most dangerous to own going forward.
The Hong Kong exchange has a complex set of requirements for companies to list. According to a recent Morgan Stanley report on the HCFAA and its implications, a company is required to, among other things, have a market cap of at least HK$2 billion at the time of listing and latest annual revenue of at least HK$500 million. In addition, they are required to have a positive three-year aggregate operating cash flow of HK$100 million or more.
Rothman pointed out, however, that he believes the Hong Kong stock exchange will probably make some changes to its listing requirements.
“I suspect there will be changes to the Hong Kong market to accommodate the better quality of companies that have to leave here,” Rothman added. “I also expect Beijing and Hong Kong would change the rules to allow mainland investors to invest in companies like internet companies.”
There will be some companies, though, that don’t qualify. Companies that don’t meet those requirements will likely look for buyers in private equity deals, after their stocks have been battered either by news or by rumors leading up to the delisting.
“It will be a very bad outcome for American investors if they are cashed out
rather than getting new shares tradable on the Hong Kong stock exchange,” said Harvard’s Fried. “Investors should understand what is going to happen to these firms. They are relatively safe in the bigger companies, but they are more vulnerable with the smaller companies.”
An example of the smaller companies that went public in the last two years with huge hype that could be potential pitfalls include Qutoutiao Inc., a mobile content company which went public in September 2018, which has tumbled 98% on an all-time basis. It currently has a market cap of around $81.6 million. Another controversial company is iQiyi Inc., a video streaming company, trading down 79% on an all-time basis. The so-called
Netflix of China went public in March 2018 but was the target of a scathing report by short seller Wolfpack Research, and most recently, regulatory uncertainty. IQIYI has a US market cap of $3.57 billion.
For investors holding some of the smaller companies, it’s worth considering taking some losses now, before they completely disappear from US exchanges. And for those US retail investors who want to be part of the huge growth in China, it makes sense to work with professionals who won’t have any issues holding foreign shares.
This opinion column first appeared in MarketWatch
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