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Why China's IPO listings are like winning the lottery

Photo by Cancan Chu/Getty Images

While China’s stock market has been ice cold over the past six months, falling by close to 50% as a government-orchestrated rescue plan unravelled, there’s one part of the market which remains white hot: initial public offerings (IPOs).

On the back of a government-imposed ruling capping valuations of new listings at 23 times earnings, around half the valuation of the broader market, along with the introduction of legislation from China’s securities regulator, the CSRC, that investors will no longer have to pay upfront to participate in initial public offerings, demand for new offerings has skyrocketed.

According to Bloomberg, in the past two weeks the six companies that have offered shares to investors were more than 1,800 times oversubscribed, attracting orders worth 7.1 trillion yuan in value.

In US dollar terms that equates to US$1.08 trillion, or roughly the same value of all firms listed on the ASX combined.

Big money.

The combination of grossly undervaluing new listings, along with investors not requiring an initial deposit to participate in an IPO, has led to a lotto-like scenario developing across China’s IPO market.

While increased demand has seen the chance of obtaining shares diminish significantly – according to analysis conducted by Bloomberg, the odds of obtaining an allocation to recent IPO listings was just 0.05% compared to around 0.5% under the old system – for those that do, it almost guarantees an instant windfall for investors.

“Returns are guaranteed,” Wang Zheng, the Shanghai-based chief investment officer at Jingxi Investment Management Company told Bloomberg. “That’s why everyone is so willing to participate in bidding and demand for new shares is so high.”

Given the returns for prior IPO listings, it’s little wonder than investors continue to flock to the market.

The table below, courtesy of Credit Suisse, reveals the IPO returns seen in the first half of 2015.

No, that’s not a misprint. Each month the average IPO returned greater than 100% after just 20 days of trade. Amazing numbers, akin to winning the lottery for those lucky enough to obtain an allocation.

“Individual investors believe the upcoming IPOs will bring them ‘risk-free’ returns as usual—they will move their money from the money market and WMPs to the equity market to chase better opportunities,” Credit Suisse wrote.

“The new stock prices were controlled by regulators at a ‘reasonable valuation’ to protect the interests of small retail investors. Therefore, investors believe the return of buying new stocks offers a risk-free return, which is sort of guaranteed by the regulator.”

Essentially the government, through the CSRC, substantially undervalues the value of a firm before listing, at least based upon the eye-watering price to earnings ratios for small-cap stocks listed in China, ensuring enormous initial profits for investors in the days following an IPO listing.

Now that the regulator-imposed ban on IPOs has been lifted, something that was introduced during the height of the 2015 stock market rout to prevent even greater market losses, the belief that IPOs will offer mind-boggling risk-free returns is now as strong as ever despite recent weakness in the broader market.

Bloomberg note that new IPO listings account for all of the best performing stocks on the Shanghai Composite this year.

Jiangsu Jingshen Salt & Chemical Industry Company has almost tripled since listing on December 31 while the Beijing Qianjing Landscape Company, an architecture firm that listed on the same day, has surged by 72%.

“Though the stock market isn’t performing well, IPO shares will still rise after listings,” Guo Feng, an investment adviser at Northeast Securities told Bloomberg. “As long as offer prices are curbed, bidding for IPOs will be crazy.”

While the government’s attempts to prop up the broader market have failed, it’s clear that their intervention in the IPO market remains as influential as ever.

You can read more from Bloomberg here.

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