For small investors, STAR brings opportunities, challenges

Investors in Chinese A-share stocks now face a big, unprecedented challenge. A new, game-changing reform allows companies that are yet to turn profitable to list on stock exchanges. This calls for new ways of valuing their initial public offerings.

Even if investors fail to arrive at the right valuation in their first attempt, they need not panic because the market's ability to allocate resources wisely has been strengthened by the new reform.

On Jan 23, Suzhou Zelgen Biopharmaceuticals Co Ltd became the first not-yet-profitable company to list on Shanghai's sci-tech innovation board, or the STAR Market. Zelgen's shares rose 120.94 percent to close at 74.59 yuan per share ($10.7) on their opening day of trading.

On Jan 20, UCloud Technology Co Ltd went public on the STAR Market, becoming the first A-share company to use the dual-class share structure. Under the structure, founders and public shareholders hold different classes of shares, with founders' shares having higher voting rights.

Zelgen and UCloud listings signify the STAR Market's easier listing standards, and mark a milestone in the history of the A-share market. They signal that market-based reforms may soon lead to stronger support for tech companies and an overhaul of imprudent investor behavior.

The A-share regulators had banned floats of tech firms yet to make profits or using special share structures since the market started nearly three decades ago.

To be sure, this arrangement, in itself, may not be adequate to fully aid the country's increasing efforts to support high-tech companies. After all, tech firms frequently use dual-class share structures to protect founders' control over the company when seeking equity financing. When it comes to reporting profits, that depends on the company's business model and its development stage.

For instance, no one would deny that Amazon is one of the world's greatest tech companies. However, as long as 17 years back, after it went public on Nasdaq in 1997, the firm did not report meaningful profits for consecutive fiscal years.

But, had the A-share market remained stuck with the old listing standards, then only continuously profitable firms would get listed. The market could fail in nurturing sincere Chinese tech giants that disclose losses but have tremendous potential for future business success.

The STAR Market's easier listing standards have allowed many not-yet-profitable firms with technological strengths to receive funding support from the A-share market－a mechanism that helps funnel more social capital into priority or productive sectors like high-tech.

Now, the capital market expects easier standards will be gradually applied to the wider marketplace. The revised Securities Law, which will take effect from March 1, has changed the requirement of issuing new shares from "capable of continuous profitability" to "capable of continuous operation".

Zelgen and UCloud are among the initial set of companies that have taken advantage of the new listing rules to go public. More firms are expected to follow suit.

By Feb 5, some seven companies have sought to list on the STAR Market via the fifth set of listing standards, which has no requirements on profit or revenue in recent fiscal years. They represent about 3.4 percent of the firms that have filed IPO applications on the STAR Market so far, according to Wind Info.

Zelgen and UCloud have received high valuations. Zelgen was priced at 33.76 yuan per share, or 56.74 times its research and development expenditure, according to company disclosures. UCloud was priced at 33.23 yuan per share, or 181.85 times its earnings per share, versus an average of 59.48 times for comparable A-share companies with ordinary share structures.

The two listings may have been overvalued, as a result of investors' enthusiasm for the landmark IPOs, the scarcity of similar investment targets, and, most importantly, the lack of ability to accurately price these unfamiliar types of companies.

Nevertheless, this will likely strengthen the pull of the STAR Market for not-yet-profitable tech firms eyeing an overseas float.

A-share investors are long used to a simple way to price new shares: pricing them at the unwritten regulatory ceiling of the price-to-earnings ratio of 23. Under such a price ceiling, investors almost do not need to value IPOs based on their fundamentals, since buying lower-valued IPO shares can easily generate returns as high as 100 percent after the shares become tradable in the open market.

Zelgen's listing not only abandoned this ceiling in compliance with the rules of the STAR Market but forced investors to find other valuation ratios as the company has negative earnings.

This has posed a challenge to investors. To price the shares of a company such as Zelgen, investors need to gain a deep understanding of the nature of its business model and the company's outlook for the future. This can prove to be a difficult task for investors who, under the old IPO mechanism, had made a habit of seldom looking closely at a company's fundamentals.

But I expect that investors will rapidly become skilled at pricing not-yet-profitable and special-share-structure firms as the market-oriented arrangements of the new board take effect.

If an IPO price is overvalued, the share price may fall below the issue price after the firm debuts on the STAR Market. In such a case, investors who subscribed the new shares at the issue price may face losses.

This will likely help investors, especially institutional ones, to mature rapidly. Investors without the ability to evaluate the shares properly will face increasingly more losses and be driven out of the market.

I believe that as time goes by, pricing will become more efficient on the STAR Market as investors gradually learn how to understand the advantages and risks of business models used by various tech firms.

I would particularly point out one risk that investors in both the Chinese mainland and Hong Kong seem to ignore: in the long term, the agency problems inherent in the dual-class share structure could impair company profitability and minority investors' interests.

The agency problem refers to a conflict of interest that the management, as the agent for shareholders, might face. A company's management is supposed to make decisions to maximize shareholder wealth, but may actually be inclined to maximize their own wealth.

The dual-class share structure will magnify the problem as small shareholders give up the right to replace the executives, even if they palpably take advantage of their majority voting rights to approve decisions that dampen shareholder wealth.

In mature capital markets such as the United States, investors take related risks into account by discounting the valuation of companies using dual-class shares as much as 30 percent lower than comparable firms with ordinary share structures. In China, agency problems become more severe due to insufficient investor protection, particularly between majority and minority shareholders.

Indeed, investors are exposed to higher risks under the registration-based system, in terms of either judging whether an unprofitable company will succeed over time or understanding the implicit risks of the dual-class share structure.

But this should be the beginning for them to educate themselves into mature investors who thoroughly understand business models of listed firms, instead of chasing after price bubbles.

I believe that the registration-based reform will play a pivotal role in elevating the efficiency of China's capital markets in allocating resources and supporting more high-tech companies.

Chen Xin is a professor at the Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University.