The Motley Fool

3 Thoughts on China’s New Star Market

The brand new tech-oriented exchange in Shanghai, the Star Market, is Chinese President Xi Jinping’s political brainchild – created to encourage domestic technology start-ups to list locally rather than overseas (such as on the Nasdaq in the US). There’s been a lot of euphoria surrounding its first trading day but now that the dust has settled, here are my three initial thoughts.

Volatility still in play

Chinese equity markets are often retail-driven with investors chasing news flow and momentum instead of earnings fundamentals. While there was no price limit during the first week of trading, an eventual cap of 20% per day will be set, which is double the 10% daily limit on other boards within China.

The Star Market will also be limited to individual investors that satisfy two main conditions: having an average daily balance of at least RMB 500,000 (US$75,000) and two years’ trading experience. But given the volatile first trading day, the threshold appears quite low. The Star Market will also permit short-selling, which is likely to instigate sharper price swings.

Moral hazard and capital misallocation

Given the fanfare and palpable government support for the Star Market to succeed, it is not inconceivable to believe that China’s National Team, a group of brokerages, banks and corporations, would buy shares amid a prolonged sell-off.

Besides the moral hazard created, these interventions would undermine Beijing’s attempts to channel liquidity into more productive sectors of the economy. This comes after China reported GDP growth of 6.2% year-on-year in the second quarter, the lowest official rate in 27 years.

Less fundamentally-driven

Unlike stocks debuting on the Shanghai and Shenzhen exchanges, which are capped at price-to-earnings (PE) multiples of 23 times the previous year’s earnings, no such restriction exists on the Star Market.

On the first day of trading, many stocks on the board were valued with PE multiples in the triple digits, with the mean valuation at 52 times, a generous multiple considering none need to be profitable at the time of listing. Buying stocks at high absolute levels is not uncommon but when company valuations are inflated, capital becomes less efficient.

Foolish last thought

The 25 companies listed spent a tenth of revenue on research and development, almost four times the proportion of those listed on the mainboard. As Beijing and Washington extend the current trade dispute, it’s particularly important (if not necessary) for China to cultivate domestic technology innovation. I believe that those willing to invest at high multiples – for firms that are actively engaging in innovation – will benefit more over the long term. But given that not everyone will be profitable, investors will want to exit when things look bad.

But for the Star Market to fulfill its purpose, capital deployment needs to be patient, with more of a focus on their innovation than the share price. As a stock with a similar theme, yet with less volatility, I’ve been a big believer in Hong Kong Exchanges and Clearing Limited (SEHK:388). The stock exchange operator recently launched new rules that included dual-class shares for technology stocks (weighted voting rights), as well as pre-revenues for biotech companies, and also provides investors with a 2.5% dividend yield.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Hong Kong contributor Christopher Chu doesn’t own shares in any companies mentioned.