Article / 09 July 2015 at 23:58 GMT

China shares bounce back, but is it sustainable?

China Watcher / Shanghai
China
  • China has taken steps to stop the equity crash, with varying levels of success
  • Many observers feel Beijing should let this sharp correction run its course
  • But Beijing wants to avoid any unrest resulting from deep investor losses


By Neil Flynn

My experience of living in Shanghai has led me to realize that China has its own unique way of doing things, that is quite often confusing, ridiculous, and unpredictable, but in the end it usually works out. The market rally and crash seen over the past 12 months has all the traits of China: the gambling-like speculation fueling the rally, a whole new generation of investors that is trying to run before it can walk, and a demand for the government to bail them out when things go wrong.

Investors have been keen to reduce their exposure to anything remotely Chinese, and the losses that some large Chinese firms have endured over the past few weeks have been huge. Online cosmetics retailer Jumei lost over 30% of its market cap between June 17 and Wednesday July 8. Likewise Qihoo, which is currently considering a management led buyout bid valuing the firm at $77 per American Depository Share, lost 20.8% of its market cap over the same period, despite the likelihood of accepting the bid being highly likely.


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Large tech firms became increasingly attractive as China's share rout continued, making a relief rally inevitable. Photo: iStock
 

Multi-billion dollar firms have been experiencing double digit percentage swings on a daily basis, causing them to trade like a small cap firm worth only a tenth of their value. This volatility has exacerbated the decline, and investors have simply being cutting their exposure to China entirely, as the outcome of China’s equity market decline has yet to become clear.

Beijing steps in

The Chinese government, through its various entities, has announced a wide range of policies in order to stop the equity crash, with varying levels of success. This has been analyzed a lot in the market. A common theme is that the government shouldn’t be hastily trying to support the market, when it was happy to do nothing about a huge rally based on nothing more than leverage-fuelled speculative trading, because market forces are simply trying to correct equity values back to reasonable levels.

This is an argument that I agree with. But as I discussed in a previous research piece, it’s somewhat meaningless throughout the rest of the year, because the government will save the market. This I am adamant about, because the government will want to avoid at all costs the public unrest that would occur if enough people have to accept significant losses.

The past two trading sessions have seen major gains for US listed equities, but the question remains: is this recovery sustainable? The investor reaction to the equity crash was to sell exposure to China, which saw the likes of Jumei and Qihoo falling by more than 10% a day. And whilst it was difficult to see an end to the rout, large Chinese tech firms were becoming more and more attractive as the rout continued, making the relief rally inevitable.

Privatization wave under scrutiny

The equity market rout has especially taken its toll on firms that have received buyout bids from their own management. The intention is to delist from the US, and relist in China, because valuations are a lot higher, and hence the amount of money that can be raised is greater.

But with many of these firms trading below their pre-announcement price, two questions arise. Firstly, the majority of the privatization bids were made in May and June, when equity markets were high, and the ability to raise capital both in private and public markets was much better than it is now. Therefore investors may be concerned that after the 30% fall over the past few weeks, do these firms still have enough capital to finance the deal? Secondly, after the rout on US-listed Chinese companies, there may be a risk that management will look at their original takeover bid, and withdraw it, with the intention of offering a lower price.

I actually expect that of the several dozen Chinese firms that have received management led buyout bids, half of them will be withdrawn, for either of the two reasons outlined above, or a mixture of both. However, it will take time, because if management were to make a decision on their bid in the current climate, it would be naïve, because it seems that China is on the precipice right now, and the chances of the markets finding a bottom or continuing to fall are equally likely.

The initial signs of a halt to the rot are good, but after the loss that has preceded it, investors will need more evidence to know whether the decline has reached a bottom, or whether this is just another case of a calm before the storm.

– Edited by Robert Ryan

Neil Flynn is a portfolio manager at Alcuin Asset Management. Follow Neil or post your comment below to engage with Saxo Bank's social trading platform

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