Photographer: Wu Hong/EPA

The 57%-a-Year Chinese Stock Trade That Regulators Want to Stop

  • Smallest China stocks post big returns on reverse merger bets
  • Waiting list for IPO approvals has fueled demand for shells

One of China’s most unusual, and lucrative, investment strategies is coming under fire as policy makers crack down on a stock-market anomaly that they helped create.

The strategy’s simplicity -- and effectiveness in exploiting the unintended consequences of state meddling in markets -- has for years made it irresistible to China’s individual investors, even as it elicited scorn from disciples of fundamental analysis.

Executing the trade is easy: just buy into companies with the smallest market values, regardless of their business prospects, and hold on in the hope they’ll turn into targets of reverse mergers. Such deals -- when a private firm purchases a public “shell” to take over its listing -- have proliferated in China as the regulator made it difficult for companies to gain approval for initial public offerings.

The result has been stellar performance by stocks with little to offer aside from their spot on a Chinese exchange. An investor who bought stakes in the nation’s 10 smallest listed companies at the beginning of the year, sold them after 12 months and repeated the process would have taken home an annualized return of 57 percent in the 10 years through the start of 2016, or more than three times that of China’s CSI 300 Index. In the past two years, about two thirds of the smallest firms have announced merger plans, according to data compiled by Bloomberg.

More recently, though, the strategy has faltered. The smallest stocks have dropped an average 1.2 percent this year as China’s securities regulator rolled out measures to curb reverse mergers under the guidance of a new chairman.

Whether this marks the trade’s demise depends on how quickly the China Securities Regulatory Commission follows through on its reform pledges, according to Zhang Haidong of Jinkuang Investment Management. The recent crackdown is unlikely to have a lasting impact on its own, but if policy makers adopt an IPO system where market participants -- rather than the government -- determine the size and timing of deals, demand for reverse mergers will plunge, he said.

“The phenomenon means our stock market is way behind the developed markets,” said Zhang, the chief strategist at Jinkuang in Shanghai. “The CSRC needs to let all companies qualified for going public list on the exchange freely without restriction. Only by doing so will the value of shell companies decrease.”

The CSRC didn’t immediately respond to a faxed query. The CSI 300 Index of shares in Shanghai and Shenzhen slipped 0.2 percent on Thursday, extending this year’s drop to 12 percent.

For a QuickTake explainer on China’s managed markets, click here.

While Chinese policy makers have always had oversight over the pace of IPOs, they’ve been especially wary of new listings in recent years, fearing that an oversupply of new shares would depress valuations in the $6.3 trillion market. The waiting list for IPO approvals exceeds 800, more than China’s total listings over the last five years, according to the CSRC website and data compiled by Bloomberg. Companies keen to go public have turned to reverse mergers as an alternative path to gaining the fundraising and liquidity advantages of an exchange listing.

Unsurprisingly, public companies with the lowest market values are often the most cost-effective targets for such deals. Six of this year’s 10 smallest companies have announced or revived merger plans since Jan. 1, the same proportion as in 2015, data compiled by Bloomberg show.

Consistent Gains

Shenzhen CAU Technology Co., which ranked among the smallest companies in seven of the last 10 years, has long been a subject of reverse merger speculation. While the firm denied it had such a plan as recently as August 2014, this year it announced a restructuring that involved buying pharmaceutical assets while divesting real estate holdings. The shares surged 461 percent in the three years through December.

Gains from betting on China’s smallest companies have been remarkably consistent, suffering just two down years over the past decade. They came in 2008, during the global financial crisis, and in 2011, when regulators pursued a short-lived crackdown on reverse mergers.

The strategy’s 57 percent annualized return over the 10 years through the start of 2016 -- which excludes suspended shares and those on the nation’s ChiNext board, where reverse mergers are banned -- compares with the 8.4 percent annualized advance in shares of billionaire Warren Buffett’s Berkshire Hathaway Inc. and 30 percent for Inc., one of the U.S. stock market’s best performers over the past decade.

Some of the gains in China might be explained by a “small-firm effect,” the idea that companies with lower market values tend to outperform over the long run, said Hao Hong, chief strategist at Bocom International Holdings Co. in Hong Kong.

New Rules

Even with that tailwind, though, there are risks. One of the biggest is that a reverse merger -- often called a "major restructuring" in exchange filings -- may never materialize, even after it’s been announced.

Among the six companies that disclosed reverse merger plans from this year’s 10 smallest stocks, none have completed the transactions so far, and only one of last year’s batch has finalized its deal.

Gansu Huangtai Wine-Marketing Industry Co. announced a major restructuring in February, only to terminate the plan in March. While shares reached a four-year high in May, they’ve since dropped 33 percent amid media reports that regulators tightened rules on reverse mergers and news that the company is being probed for disclosure-related violations. A call to the office of Gansu Huangtai’s board secretary went unanswered.

IPO Reform

Policy makers are revising major restructuring rules to curb speculation linked to reverse mergers, CSRC spokesman Deng Ge said at a briefing in Beijing last month. Authorities have already tightened regulations on cross-sector deals after companies in slow-growth industries rushed to offer their shells to firms in so-called new economy sectors such as Internet finance, Caixin reported on May 11. The regulator is also weighing restrictions, including a cap on valuation multiples, for reverse mergers involving companies previously listed overseas, people with knowledge of the matter said in May.

“In the short term, the crackdown will lead to a significant decline in values of shell companies,” said Qiu Dongrong, who helps oversee about $2 billion as a money manager at HSBC Jintrust Fund Management Co. in Shanghai. “But on a longer horizon, it can be interpreted as positive news, as the tightening is aimed at restoring the market’s normal fund-raising functions.”

The easiest way for authorities to curb the popularity of reverse mergers would be to loosen the state’s grip on the IPO process. While China is planning a new registration-based system that restrains the government’s ability to control the pace of share sales, CSRC Chairman Liu Shiyu said in March that policy makers need more time to prepare the rules.

“It’s insane that the worst companies often get wooed” for reverse mergers, said Bocom’s Hong. “Hopefully this will change.”

— With assistance by Shidong Zhang, and Fox Hu

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