Red-Hot Chinese Stock Strategy: Buy Unprofitable Companies

A Look at China's New Growth Drivers
  • Money losers have gained an average 60 percent this year
  • Weak firms are targets of reverse mergers, restructuring

In a year full of surprises for China’s equity market, here’s another one to ponder: loss-making companies are some of the country’s best-performing stocks.

Not only have they trounced the Shanghai Composite Index with an average 60 percent gain in 2015, money-losers are also outperforming China’s most profitable companies by 5 percentage points. In the U.S., by contrast, shares of loss-making businesses have tumbled an average 15 percent.

While it’s tempting to discount the outperformance as a sign of irrationality among China’s 97 million individual investors, there is a certain logic to it. Loss-makers are prime targets for Chinese policy makers seeking to improve the efficiency of state-owned companies and reduce industrial overcapacity via mergers. Reverse takeovers, meanwhile, are unlocking the value of stock-market listings at businesses too far gone to repair.

Yet the risk for investors is growing. Several companies have come under fire from regulators this year after failing to follow through on restructuring proposals, while a KGI Securities Co. analyst estimates that less than 10 percent of unprofitable companies will succeed in restructuring. If China follows through on plans to make it easier for companies to list shares through initial public offerings, demand for reverse takeovers is likely to plunge.

“As an IPO registration system is being set up, we may see less speculation on shells,” said Ken Chen, a Shanghai-based analyst at KGI Securities. “If we look back three years later, we will probably find that less than 10 percent of these loss-making companies were successfully transformed.”


The prospect of quick, event-driven returns has proven especially enticing for Chinese investors after the nation’s economic slowdown deepened and a $5 trillion stock-market crash undermined the appeal of a buy-and-hold approach. The Shanghai Composite, which tumbled as much as 43 percent from its June peak, has gained 9 percent this year. The gauge added 0.3 percent at the close on Monday.

In China, there’s no shortage of unprofitable companies to choose from. Some 452 firms on mainland exchanges have reported trailing 12-month losses, accounting for about 16 percent of overall listings. One of them, Luoyang Glass Co., more than quadrupled in Shanghai trading this year despite losing 162.3 million yuan ($25 million) in the 12 months through September. Shares surged after the company agreed to shift loss-making assets to its state-owned parent.

"With a bleak economic outlook, rumors and restructuring stories become even more influential," said Daniel So, a Hong Kong-based strategist at CMB International Securities Ltd.

Backdoor Listing

At least 17 companies have completed reverse mergers this year, twice as many as last year, and another 26 deals are still pending, according to data compiled by Bloomberg. A record number of Chinese companies are seeking to de-list from U.S. bourses, with many of them planning to move their shares to mainland exchanges where valuations are higher.

Chongqing New Century Cruise Co., which operates river boat tours and lost 16 million yuan in the 12 months to September, rallied fivefold in 2015. The stock jumped by the 10 percent limit for 18 straight days after agreeing to be taken over by Shanghai Giant Network Technology Co., a developer of online games controlled by billionaire Shi Yuzhu, as part of a backdoor listing.

Not all takeover plans materialize. Zhejiang Honglei Copper Co. has tumbled 33 percent since the China Securities Regulatory Commission warned the company in August about failing to take action over a publicly-announced acquisition. In September, the regulator fined the chairman of Sichuan Jinyu Automobile City (Group) Co. for spreading fake news about the company’s reverse merger. Shandong Qixing Iron Tower Co., an unprofitable builder of transmission towers, that surged more than 400 percent in 2015, said on Nov. 28 that a purchase plan announced a year ago has yet to receive official approval.

Slowing Growth

It’s becoming harder for companies to rebound from losses amid the weakest economic growth in six years. Profits at Chinese industrial companies dropped 4.6 percent in October and manufacturing conditions deteriorated last month to the weakest level in more than three years. Earnings have trailed analyst projections at a majority of index companies for eight straight quarters, while a majority of companies that were unprofitable in 2012 are still losing money.

Reverse mergers -- used by privately-held companies to gain a stock-market listing without an IPO -- will become less attractive if China adopts a U.S.-style registration system where authorities don’t determine the timing or valuation of deals. Under China’s current regime, companies have faced long regulatory delays and periodic market-wide freezes on share sales. Policy makers are ready to unveil plans for a registration system as soon as next week, Reuters reported on Friday, citing two unidentified people familiar with the matter.

"Shells will stop being a rarity under a registration system," said Chen Xingdong, the Beijing-based chief China economist at BNP Paribas SA. "Overvalued small caps will gradually return to reasonable prices.”

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