China: Valuations driven down by short sellers
Rumours knock Ping An down 14% in a day; Soc Gen predicts big rally
Short-sellers crowding into Chinese stocks are driving valuations down and increasing market volatility, according to analysts that cover the market.
Todd Martin, Asia equity strategist at Société Générale, says he began looking at the actions of short-sellers more seriously on September 26 when shares in Chinese insurance and banking group Ping An fell dramatically, with the H shares down 13.7% and the A shares down 9.58%.
"At first nobody could work out why Ping An fell 14% in one day," Martin says. "I was reminded of 2009 and the similar situation with HSBC’s stock plunging unusually. Once Ping An denied they were raising capital, and that shareholders were pulling out, it dawned on me: the market is being manipulated. The short-sellers are on the rise."
Short positions in Ping An rose to 5 million shares on the 26th, Martin says, amid market rumours that big shareholders in Ping An, including HSBC, were pulling out and that the company would have to raise capital. The company has denied all these allegations, and the shares bounced back up from the low of HK$42.40 on the 26th to HK$46.80 on the 27th.
Ping An’s plunge was unusually severe but the company is not alone: a combination of factors has made Chinese stocks particularly sensitive to market rumours, and short-sellers are piling into the market in anticipation of easy profits as global market volatility makes investors panicky.
"Once Ping An denied they were raising capital, and that shareholders were pulling out, it dawned on me: the market is being manipulated. The short-sellers are on the rise"
"China is now the world’s most crowded short in my view," says Martin. "Short volume as a percentage of total volume is 9%, a 2.2x 13-year standard deviation event."
Chinese stocks, especially those listed outside the mainland, have been targeted all year by short-sellers, who identify what they claim are errors or deliberate fabrications in the companies’ publicly filed reports. The actions of short-selling research companies such as Muddy Waters have led to the de-listing of many Chinese stocks, with Sino Forest and Longtop among the higher-profile examples. Now, though, their efforts have led to widespread mistrust of Chinese companies in general. (see What’s behind the great China stock scandals?, Euromoney September 2011)
"Chinese companies provide relatively easy targets for these tactics," writes a Fitch Ratings analyst in a report entitled Whistleblowing short-sellers a double-edged sword. It continues: "The domestic analytical investor base is less developed than Western peers, the country has poor rankings on corruption indices, and companies have concentrated ownership structures. Combined with strong growth expectations and a desire by local and foreign capital to participate in this growth process this increases the potential for unusual practices and sometimes fraud."
The mere threat of a company being targeted by short-sellers can make investors nervous, driving up credit costs for the company as it has to pay out higher yields. Even if a company targeted by negative research or market rumours manages to refute all the allegations, it can still suffer.
Fitch says: "Experience demonstrates that even in a situation where the allegations are wholly unfounded, this sort of coverage is likely to wreak significant reputational damage, at least in the short run. This can severely influence debt and equity prices, and tackling such untimely headlines absorbs management time, disrupts customer and supplier relationships and reduces access to sources of funding."
The problem is exacerbated by investors’ tendency to view Chinese stocks as a discrete asset class, rather than differentiating between sectors and between industry leaders and newcomers in the way they would with, say, US companies.
"Like it or not," says a fixed-income portfolio manager at a leading global asset manager, "China is an asset class and not all investors have the resources and the willingness to do the work necessary to separate the good from the bad. These problems [with fraud and misreporting of revenues] are not unique to China: think Enron, WorldCom and so on."
Although Ping An was not accused of fraud, its plunge on September 26 demonstrates the acute sensitivity of China stocks to market rumour and the self-reinforcing nature of short-sellers targeting these stocks. If the situation continues, Société Générale’s Martin says, Ping An and Chinese stocks in general could be on the verge of a short squeeze, a situation in which a sudden rapid recovery in a stock’s price forces short-sellers to liquidate their positions and thus drives the shares even higher.
Aside from the research published by short-sellers, there are of course more macroeconomic reasons why investors are more sceptical now about the China story. These include persistent concerns about the ratio of non-performing loans in Chinese local government finance vehicles, and worries that tightening credit conditions will hit the over-leveraged property sector particularly hard and lead to a sudden collapse in the market.
Investors on the mainland and in Hong Kong seem to have differing views on the market: as of September 28 the A to H share premium was 22.4%, suggesting much more confidence among investors on the mainland than in Hong Kong.