POLISHING GEM
Hong Kong's Growth Enterprise Market is shining for Chinese companies.
By Jasper Moiseiwitsch

The Growth Enterprise Market (GEM), the second board of the Hong Kong stock exchange, has fully lived up to its official "buyers beware" billing. Launched in late 1999, the opening of this exchange was ideally timed for Asia's late, great internet bubble. All manner of portals, data-center ventures and e-tailers listed on GEM through 2000, and these saw their share prices soar and dive in a great, Icarian arc.

To put it politely, the bust damaged the exchange's reputation. The GEM index has sloped from a base rate of 1,000 to its current home in the low 140s. In 2000, GEM's boom year, the exchange raised HK$16 billion (US$2 billion). In 2001, that figure was HK$5.8 billion (US$744 million). Daily turnover fell by half in 2001 from the preceding year, notwithstanding the addition of 57 listed companies.

Despite all these sad facts, the bourse has summoned a curious renewal in 2002. Companies are returning to list on the exchange and total issued capital is approaching growth similar to that seen in 2000. In the first seven months of 2002 the exchange raised HK$7.1 billion in total equity funds - a greater number than for all of 2001. A good part of that sum, HK$2.9 billion, is attributable to the listing of the Li Ka-shing-controlled bio-tech venture CK Life Sciences, in July, which has boosted GEM's profile and turnover.

But much of GEM's momentum this year comes from China - about 35 percent of the firms currently listed on GEM are based there. Lawrence Fok, the deputy chief operating officer at Hong Kong Exchanges and Clearing (HKEx - the parent company of the Stock Exchange of Hong Kong) says China's expanding economy has created a long list of GEM candidates.

The attraction is clear. Although the Shanghai and Shenzhen exchanges generally offer a higher PE than GEM (about two times richer), GEM has easier listing requirements and offers access to foreign currency and international investors.

GEM was designed for companies with little track record and few options to raise capital. Candidates need only show two years of "active business pursuits" (profits not required) prior to listing, and a HK$46 million market cap. .

Muddle Earth

Mainland listings, by comparison, are often subject to a difficult and seemingly arbitrary approval process. Calvinna Yang, the CFO of GEM-listed Beijing Beida Jade Bird Universal Sci-Tech, says this can tilt Chinese companies in favor of GEM. "In Hong Kong, you just have to follow all the procedures laid down by the stock exchange," says Yang. "But in China the rules and regulations may not be so specific as in Hong Kong. The PRC officials have the power to say you are doing it the wrong way. Then you have to go back and prepare the documents again," she says.

And, unlike the domestic Chinese exchanges, GEM offers a pipeline to foreign capital. Mainland companies needing foreign exchange can apply to China's foreign exchange bureau. But this involves a lengthy application explaining why it needs this currency, and would likely be turned down without detailed, documented reasons.

At Jade Bird, which designs software and integrated circuits, Yang says a GEM listing resolves foreign currency needs in two ways. First, companies can legally raise foreign currency with ongoing GEM issues. Second, being listed outside of China gives a company an international status that eases applications to convert renminbi with China's forex bureau.

Chinese firms like GEM for other reasons. Companies that wish to expand overseas can find strategic investors via a GEM listing. Henry Mok, the financial controller of the Chinese firm Greencool Technology, says Greencool's GEM listing linked the firm to institutional investors in the UK, US and Singapore, who have helped with the company's business development. Greencool distributes CFC-free refrigerants in China.

Buyers Beware

That's the good news about GEM. Unfortunately, the exchange continues to be dogged by investor skepticism about the quality of listed companies. For example, Greencool Technology's share price fell 10 percent in July after the influential Caijing questioned the company's stated figures.

The magazine wrote that Greencool Technology's parent, Greencool Refrigerant, reported turnover in 2000 of 3.3 million renminbi (US$399,000). The figure is stated in an auditor's report, which has been seen by CFO Asia. Greencool Refrigerant is the sole supplier to Greencool Technology. Greencool Technology reported a cost of sales of 67 million renminbi (US$8 million) for 2000, which Mok says relates mainly to the cost of coolants bought from Greencool Refrigerant. Why did Greencool Technology report paying about 67 million renminbi for coolants when its sole supplier only reported 3.3 million renminbi in revenue?

Mok won't say, noting that Greencool Refrigerant's turnover figures are a private matter relating to Chu Jun Gu, who controls Greencool Refrigerant and is also chairman of Greencool Technology. He adds that there will be no restatement of Greencool Technology's audited figures.

More worryingly, many of the ventures that were prominent on GEM in 2000 failed to develop quality businesses. Many have lost money or put their IPO funds in the bank to collect interest. In either case, they have generated poor returns on invested capital. Says Edmund Harris, a Hong Kong-based fund manager with Investec Asset Management, a large international investment banking house: "I don't invest in GEM stocks, partly because they don't match the very stringent and rigorous investment parameters that we apply. I haven't seen one that I like."

Decline and Fall

The share prices of newly listed firms reflect this skepticism. The 28 companies that listed on GEM in the first six months of 2002 saw an average share price drop of 42 percent, which invites the question: who keeps buying this stuff?

In a typical GEM listing, about 24 percent of shares are sold directly to the public, with most of the rest - 71 percent - 'placed' (sold in blocks) by securities dealers. HKEx's Fok says the bulk - 88 percent - of this placement is handled by brokerages that mainly deal with retail investors and some small institutional funds. The implication, agrees Fok, is that the retail market comprises the core of GEM's investor base.

This is bad news for companies that prefer the more stable holding of institutional investors. It also helps explain a familiar pattern of GEM listings: strong initial price performance in the weeks after IPO, followed by sharp decline. It seems that once the brokerages and funds have fully distributed their shares, they abandon their stocks to an oblivion of tepid turnover and interest in the retail market. There seems to be little follow-up sales effort, market making or research support.

Worse, the typical GEM offer process - in which a small number of parties control a large number of shares - has created suspicions among some that placing underwriters have opportunities to manipulate prices. When one corporate finance professional involved with GEM listings was asked if he believes the exchange is subject to ramping, he said: "I would be surprised if it doesn't happen." When Investec's Harris is asked the same question, he answers facetiously: "That can't possibly be true," followed by a deep rolling laugh. There have been no proven cases of ramping or price manipulation on the exchange, but the suspicion still hovers, dampening interest in long-term institutional holding of the firms listed there.

Stone Throes

Still, GEM's reputation is improving. In March 2000, three internet companies comprised 77 percent of GEM's total market capitalization. In July 2002, there were no internet companies in the top three. With this diversification has come better quality companies - about half of GEM companies are profitable.

Mainland CFOs considering a GEM listing should think beyond just the IPO funds. History suggests that future listings might find a declining share price, poor liquidity and few opportunities for follow-on issues. In the first seven months of 2002, GEM-listed companies raised HK$1.5 billion (US$193 million) in the secondary market, or only 20 percent of total funds raised. Only two companies have moved to the main board.

GEM possibly best serves as a stepping stone for other sources of funding. GEM-listed companies find that the bourse's strict transparency requirements ease the loan-approvals process, and it might smooth the way for a listing elsewhere.

Jasper Moiseiwitsch is a contributing editor at CFO Asia based in Hong Kong.