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Chinese IPOs in the US – How Low Should You Go?

So Weibo and Alibaba are planning to go public in the US. They follow a number of other Chinese companies that already went public. What has the record of these Chinese IPOs been?

US investors are generally a pretty trusting crowd. Partly this is because the word “China” makes them think of vast numbers of people and therefore presumably vast revenues and earnings. So Chinese companies look like treasure troves to many US investors, particularly unsophisticated ones. And when a new Chinese company comes to the US to go public, it’s not just the treasure aspect that is attractive. US investment banks and stockbrokers promote Chinese stocks aggressively since they all get paid commissions on the stocks they sell, even if the company is terrible or its stock performs disastrously later.

Of course, that’s exactly what has happened to many Chinese companies that went public in the US. The poster-child is Sino-Forest, whose financial statements were falsified and largely fraudulent at least under US accounting rules.

And Sino-Forest was only one of many Chinese companies whose financials were either misleading or even fraudulent. Currently there is the well-publicized example of the Chinese company Mindray whose financial statements seem to be remarkably similar to those of Sino-Forest in terms of their many problems. So now Chinese companies have a very bad reputation in the US, many being regarded as dishonest or even fraudulent.

A big part of the problem is the huge difference in auditing and accounting standards between the US and China. Right now there is a major argument between US and Chinese regulators about whether or not US regulators can get access to the working papers of Chinese auditors, with Chinese regulators so far refusing to allow that. That makes US investors very wary because they don’t know how to judge the quality of financials of Chinese companies especially after their experience up til now with some of the Chinese companies that already did IPOs and whose prices later crashed when the low quality of their financials became known.

However I can safely say that none of this will affect the IPOs of either Weibo or Alibaba nor even of other Chinese companies that plan to go public soon such as Autohome, Qunar, 58.com or Sungy Mobile. This is partly because Alibaba and Weibo in particular are relatively well-known names and partly because they have the Chinese treasure-factor behind their name.

The US stock market, like all stock markets, is partly driven by fashion rather than economic fundamentals. Right now the US stock markets are largely fashion-driven rather than economics-driven. That’s why we have the huge prices being paid for some tech firms such as WhatsApp. Right now the US market for IPOs is hot and in such markets, the US public will buy anything, even the stock of relatively unknown Chinese companies. So we can expect companies such as Alibaba and Weibo to have great public launches at least in the short-term.

In addition the investment banks and stockbrokers behind them are going to promote them with a high level of aggressiveness. In this market in the US at this particular time even for other Chinese companies that are totally unknown but want to go public right now, this is a perfect time for them to sell, no matter what the quality of their financial statements or the real underlying quality of their assets.

Of course this won’t last since hot markets never last either. Sooner or later, the US stock market will not be hot and it might even go into a mini-crash. In that case we can expect the stocks of Chinese companies to do much worse than average, at least in part because they are foreign, partly because they are Chinese, and partly because the reputation of financial statements coming out of China is also very bad in the US.

It’s ironic that the reason that many Chinese companies want to go public in the US rather than, say Hong Kong, is that is many ways the US stock markets rules allow some practices which are bad for small stockholders. In the US the New York Stock Exchange and NASDAQ allow public companies to issue Class A and Class B shares that allow the founders and partners of a company to hold a restricted class of share that gives them vastly more powerful voting rights than normal stockholders and is fundamentally inequitable to small stockholders.

Thus in these companies, despite Class B stockholders having paid the same price per share on the open market as insiders and founders, they get far less power in corporate governance. The Hong Kong stock exchange does not allow this so it’s not nearly as attractive to closely-held companies such as Alibaba.

So although the financials of many Chinese companies are suspect, in fact the US stock markets allow Chinese companies to treat small stockholders unfairly which makes them more attractive than the Hong Kong markets. So the issue of financial statement quality and corporate governance isn’t just one-way here. The US markets generally enforce more financial transparency and higher quality financials. But the US markets, at least in their favored treatment of large insiders, are significantly less fair and open than the Hong Kong market.

I think most of the smarter US investors expect the big Chinese IPOs to do well in the short-term but they have no idea how they will do in the longer-term. But with less well-known Chinese companies, I think most US investors would expect them to do well in the short-term but be likely to go down or even collapse in the longer-term. That’s because the sentiment is very negative on Chinese accounting and audit practices.

If you were a small investor in the US, I think the smart money would be to short Chinese companies, except Alibaba and Weibo. So I think we can expect the short-sellers to quickly attack many of the upcoming Chinese IPOs except for Weibo and Alibaba.

Note: This blog post recently appeared as an article in Chinese in the China Times (Beijing); it was also reposted on Sina Weibo (ironically), see here if you want to read it in Chinese :)

 

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Tuesday, 13 November 2018

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