Caixin
Oct 21, 2011 03:14 PM

How Weak Companies Make Stock Investors Happy

Some of China's hottest investment targets these days are once-vibrant companies that lost a lot of money, scaled back and then switched to life support.

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What investors want from each of these struggling companies is a trading slot with a ticker symbol on the Shanghai or Shenzhen stock exchange, so they can benefit from the company's rebirth after integrating with an unlisted firm.

The buyer of a money-losing but listed company can profit after orchestrating a merger and asset restructuring with an unlisted company, and then cash in after reorganization leads to a new stock issue or higher share prices.

For investors, whether a company succeeds after such a marriage of convenience makes little difference. They can make a fortune simply by acquiring a weak company's low-value stock, riding through a restructuring, and cashing in after the share price climbs.

A key reason why investors have been able to make money by pursuing practically worthless companies can be found in China's complicated stock issuance system.

Unlike overseas markets, a company that wants to list on a Chinese exchange is required to follow a merit-based, step-by-step regulatory approval process. The process makes it significantly more difficult for companies to go public in China than elsewhere.

Companies seeking to list are first closely examined by regulators. Thus the process, which requires considerable administrative input, can take months or even years.

Companies that need financing but can't stomach the complicated listing-approval process – perhaps because they don't have time, or they fear rejection – can link to and then blend assets with a listed company that's losing money.

Potential targets are companies whose ticker symbols include an "ST" mark, which stands for "special treatment." Stock markets stamp an ST on any company that loses money for two, consecutive years.

These companies are allowed to continue trading until they post losses for a fourth, consecutive year. Then they are de-listed. Industry insiders say weak companies that want to stay on the bourse, however, may find ways to post an occasional profit and thus shed the ST symbol.

Tale of Meiyan

One unprofitable – and nearly hollowed-out – company sliding toward a delisting was Guangdong Meiyan Hydropower Co. Ltd., which specializes in hydroelectric power. Shanghai Stock Exchange officials have been formally warning traders since 2008 that its shares could get the boot.

The concern's largest shareholder, Meiyan Industrial Investment Co., held only 2.19 percent of Meiyan Hydropower stock as of early October – the lowest percentage of any No. 1 shareholder on the A-share market.

In mid-September, three Meiyan Hydropower board members, who are also Meiyan Industrial shareholders, announced their resignations as part of what they called an effort to "optimize corporate governance."

Before the announcement, Meiyan Hydropower had grabbed public attention several times by flirting with potential restructuring partners. And shortly after the announcement, Meiyan Industrial sold a large number of Meiyan Hydropower shares.

Investor reactions were mixed. Some interpreted the move as an indicator of future restructuring, but others said controlling shareholders may have already abandoned Meiyan Hydropower and any plans for restructuring.

Listed in 1994, Meiyan Hydropower was once hailed as an exemplary private enterprise. But its fortunes turned a corner with the new century, and since 2001 it's been forced to raise cash by selling 2.9 billion yuan worth of equity in its subsidiaries.

The company's main income for the first half 2011, according to its latest financial report, came from selling a 44 percent stake in an electronics subsidiary that makes computer monitors to Meiyan Industrial. If not for the sale, Meiyan Hydropower would have reported a 36.5 million yuan loss for the period.

Meiyan Hydropower's descent has not been the worst among A-share market companies in recent years. Indeed, in the past, dominant shareholders have been caught illegally benefiting by transferring listed subsidiary assets at manipulated prices.

In most circumstances, analysts note, it's hard to determine fair price for these kinds of transactions, since deals between a listed company and a subsidiary held by the controlling shareholder are usually private.

Sometimes a controlling stakeholder uses a listed company as collateral for loans taken out by other businesses. The listed company is then forced to cover any losses by liquidating assets.

Public companies, after being hollowed out, are then repackaged by the controlling shareholder into restructuring candidates, which in turn entices retail investors who snap up shares on the secondary market.

According to lawyer Wang Yi, a partner at the Junhe Law Office, it's common for a parent company to arrange a temporary swap of a listed firm's nonperforming assets for profitable assets held by another subsidiary with the same parent.

Wang noted local governments would weigh in on transfers involving state-owned assets. However, administrative interference often works in favor of a restructuring, obscuring the intent of a transfer and masking underlying problems.

Weaker the Better

Thus, the high threshold levels for allowing companies to list on the stock market, combined with a mechanism that lets weak companies continue trading stock, encourages marriages of convenience between listed and unlisted concerns.

Indeed, any A-share listed company valued at 1 billion yuan is actually worth more than 3 billion, based on its access to the stock market, said Pang Litang, a lawyer at Beijing Deheng Lawyer Office. This fact gives companies with poor financials an incentive to continue rolling down a weak performance road, since a company on life support can make a lot of money for savvy investors.

According to an investment bank analyst, an ideal candidate for a merger and asset restructuring should have low debt levels and no more than 400 million shares worth up to a combined 3 billion yuan.

Currently listed on the Shanghai and Shenzhen markets are 45 companies whose controlling shareholders have stakes of less than 10 percent. Every now and then, one of these companies stirs public attention with restructuring rumors, although in fact none meets restructuring criteria.

Most of these concerns are heavily indebted and have few, if any, performing assets. They also have a lot of shares on the market, creating high market capitalizations.

Yet history has shown that controlling shareholders can find ways to cash in when share prices rise on restructuring rumors, while retail investors get burned after a restructuring never materializes.

One veteran stock investor said it's common for a controlling shareholding company to make money by overstating an asset's value, selling it to a subsidiary that's listed, and then selling stock after the price rises on the restructuring.

Regulators have tried to ban such transactions by strengthening disclosure rules and setting penalties for managers who help manipulative shareholders.

But a prohibition can't work because "board members of a listed firm are themselves shareholders in the controlling company," said one analyst. "They effectively control the firm. There is no one to represent all other shareholders in the listed firm and protect their interests."

And despite the risks, retail investors typically pour cash into weak companies apparently preparing for a restructuring.
"No one cares about the real value of the stock anymore," lamented one investor. "They go for trash if it's going to be restructured."

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