Speculators in China lick their wounds :View from hong kong

After the crash, the collective myopia of foreigners has given way to better vision, says Stephen Vines Bull markets provide the perfect conditions for doubtful companies to gain a listing and tap the capital markets for funds: the strong Hong Kong market of 1993 and the beginning of last year was no exception.

A flood of new issues created opportunities for entering the hitherto closed world of mainland Chinese companies, many of which have proved to be disastrous investments.

There was a voracious appetite for shares of Chinese- backed companies and state corporations. Last year more than half the new capital raised on the Hong Kong stock exchange was invested in so-called "H" shares, the stocks of Chinese state corporations offering a small part of their equity to foreign investors.

Now that the market has cooled, investors are shunning China-related stocks to the point where only three of the 15 "H" shares are trading above their issue price. Price/earning ratios have tumbled to historically rock-bottom levels.

The most spectacular example of investor disillusionment with Chinese stocks is the fate of Denway Investment which was oversubscribed a record 658 times when it was launched on the market in February 1993. So much money was tied up in the issue that a temporary, but acute, liquidity problem developed in the banking system.

Denway, like a number of other mainland Chinese-controlled companies, is not classed as an "H" share because it came to the market through a Hong Kong incorporated company. Its shares are trading at just over half their issue price following publication of its interim results, revealing an extraordinary 95 per cent slump in profits.

The fall was more profound than expected but the precarious nature of Denway's business was evident from the time of the initial public offering. The company's main asset is a controlling stake in the Guangzhou Peugeot joint venture, the smallest and least successful of China's joint-venture car assemblers. The company suffers from poor economies of scale, lack of proximity to the rest of the Chinese automotive industry and a weak product range.

All these fundamental considerations were swept aside in the frenzy to acquire a stake in Denway. Although extreme, it is not untypical of the way investors have approached China-related share issues.

Another salutary lesson was provided by Kunming Machine Tool which thundered to the market with a 628 times oversubscription rate, making it far and away the most popular of the "H" share pack. Its interim results, published last September, showed a 65 per cent drop in turnover. Profits rose by 155 per cent, but half the increase was due to a tax writeback.

Sentiment has unsurprisingly turned against Kunming, with SG Warburg issuing a rare sell note. But the writing was on the wall from day one. The company is a relatively unsophisticated manufacturer of machine tools. Its products are relatively cheap but tend to be below the standard required for China's fast-growing, export-oriented industries. Meanwhile, the big state-owned companies, catering mainly to the domestic market, are facing cutbacks and have therefore reduced their purchases from Kunming.

All this information was known at the time of the issue. Kunming was popular mainly because it was second in line to bring its shares to the market and caught the enthusiasm of those who had missed out on the Tsingtao Brewery issue, which has ironically turned out to the best-performing "H" share.

The "H" share stampede, accompanied by heavy buying of other China-related stocks, known as Red Chips, was the herd instinct gone mad. The normal criteria for judging share values were brushed aside. Companies were brought to market with greatly inflatedasset valuations, based on unsustainable estimates of property values in China; they came laden with very high levels of debt, where the hope of recovery was slight, and they published earnings forecasts that were frankly misleading.

It may be cold comfort for investors in China-related stocks listed in Hong Kong but the performance of "B" shares, those open to investment by foreigners, on China's two stock exchanges has been even worse.

Last year the Shanghai "B" index plummeted by 40 per cent, while the Shenzhen market, on the border with Hong Kong, slumped by 38 per cent.

The quality of many of the "B" shares is even more dubious than the "H" shares. Regulatory standards are notably lower, disclosure and reporting requirements more lax, while safeguards for minority holders' rights are minimal.

Yet "B" shares were very much the flavour of the month during the 1993 bull market. Investors shrugged off warning signs - a failed rights issue within a couple of months of flotation, the discovery that some profit forecasts made at the time of the issue were little better than scribbles on the back of envelopes , and the tendency for companies to use the proceeds of flotations for speculative activity rather than investment in their core businesses. The collective myopia of foreigners investing in Chinese equities has now given way to much-improved vision.

At the end of last year the Chinese-controlled Oriental Metals limped into the market with subscriptions for only 60 per cent of its shares. Many potential new issues are on hold.

The new note of realism in evaluating Chinese companies is underpinned by the gruesome death-watch over the ailing Chinese patriarch Deng Xiaoping. Chinese stocks are unlikely to improve while fears abound that his demise will paralyse his economic reform programme.