Why don’t I buy IPOs (and you shouldn’t either)?
In the case of China stocks it’s because they’re nearly always overpriced and more often than not pre-IPO earnings have been manipulated to assist the over pricing. These are now established facts, not opinions.
The paper today, from Ziyi Chen of the Hong Kong University of Science and Technology and Jie Gan of the Cheung Kong Graduate School of Business provides some fresh proofs for the above contentions.
Starting with the question ‘Why have real, dollar weighted returns, for investors in China been so much lower than what a buy-and-hold review of performance would suggest?’, they take a long view of the China stock market since its inception in 1990 up to 2020.
The difference between buy-and-hold and actual returns in their study period is staggering. Buy-and-hold analysis suggests you should have made around 11% per annum. In reality they find the real return has actually been 5.8%, a very significant difference.N.B. In developed markets these numbers are never too far apart.
This failure of stocks to provide returns in sync with expectation or related to broader economic progress is a leitmotiv of developing markets. China, as the biggest, is therefore a good place to try and understand the phenomenon better.
Noting along the way high volatility, an inability to efficiently short stocks, weak investor protection and earnings manipulation the researchers believe its where all these forces combine, in capital raising, that explains how investors have been, time and again, bilked.
[Depressing to also note that by altering the start date for the study it was possible to analyze whether this process had gotten better over time. It hasn’t.]
Not only have capital raising exercises (it’s mostly but not exclusively IPOs) been serially overpriced, which in any market would lead to poor longer term returns, the overpricing is often assisted by manipulated earnings compounding the problem; it gets worse.
Some would argue if a company raises capital at a low price (i.e. a high IPO price) that’s a good thing as, over time, this cost of capital advantage will show up in superior margins. Er, nice theory.
In practice, the researchers observed companies armed with incorrectly priced capital then go on to do incorrectly priced deals with that money thereby further reducing shareholder returns in the following periods.
So China investors, if you’re being offered the chance to provide equity finance (IPOs being the most common route), it’s almost certainly at a wrong price based on manipulated prior-period earnings. Moreover, you’ll be giving money to managers likely to invest it badly.
It can’t be put more plainly.
You can access the paper in full via the following link Wealth Destruction on a Massive Scale.
Happy Sunday.