With an increasingly larger share of money being raised in the emerging markets and the attraction this hold for investors, there is increasing concern about the quality of public issues

An important part of the emerging market growth "story" is the shift in capital markets away from older financial centers like New York and London to newer financial centers in emerging markets. Proof of this shift was especially evident this year in initial public offering (IPO) activity.

IPO activity for 2010 reached a total of $263 billion, double the 2009 level. Asia-Pacific issuers accounted for 60%. China and Hong Kong supplied 75% of the Asia-Pacific total. The total amount of Chinese issues was triple the amount of new money raised in New York. This trend is supposed to continue into 2011. So far, over $100 billion worth of IPO offerings have been announced in the Asia-Pacific region.

Asian IPOs also made a splash on Wall Street. The growth ‘stories’ of technology and China are invariably irresistible. Two IPOs stand out. One was Youku.com Inc a company often referred to as the YouTube of China. The other was the E-Commerce company DangDang Inc, considered China’s Amazon.com.

Within one day of its issuance Youku soared 161% beating the previous record set by ChinaCache whose value increased a mere 95%. DangDang was not far behind with a first-day pop of 86%. With increases like these, it is hardly surprising that these new issues attract enormous amount of attention if not worship. It appears that investing in new Asia-Pacific IPOs is an easy and sure way to make money. But there is a dark side.

The first point is that although these stocks can make enormous amounts of money on the first day, they can also quickly lose value in the following trading.Youku.com subsequently lost 36% from its post-issue high. ChinaCache and DangDang lost similar amounts, falling 36% and 31% respectively.

The other problem is simply trying to take advantage of new public offerings. Getting allocations in these deals is very difficult for large institutions let alone the average investor. Retail investors are limited to the aftermarket with its attendant risks.

The other problem with these IPOs has to do with quality. According to a South China Morning Post analysis, 106 companies listed in Hong Kong in 2010. Of those, eight companies reported sudden post-issuance earnings drops, which ranged from 13.5 % to 97.4%. There were no earnings forecasts in the offering documents and the earnings surprises came without warning. Of the remaining 98 firms 46 have reported profits, and 52 have yet to report.

In the US there is a different problem. There are more than 500 Chinese companies listed on American exchanges. The vast majority of these firms did not go through traditional IPOs. Instead they found shells of US listed companies, and used a technique called a reverse merger to back-door their way into a listing.
 

The US securities watchdog, the Securities and Exchange Commission (SEC), is conducting a major crackdown on these reverse mergers due to widespread allegations of accounting misstatements and outright fraud. Over 340 of these firms used small unknown US auditing firms that often outsourced the accounting back to local Chinese firms. This produced a problem because some work papers were in Chinese and the US auditors couldn’t even read them.
 

It is not just IPOs from China that are a cause for suspicion. According to research by MoneyLife, a Mumbai-based financial magazine, IPOs in India are not very profitable either. In August of 2009 the Bombay Stock Exchange (BSE) created an IPO index, a stock index designed to track the value of recent IPOs listed on the BSE. After two years, the index is down 2%. In contrast, the BSEs’s flagship index, the Sensex, is up over 28%. According to MoneyLife, the best strategy to make a profit in IPOs involves ‘flipping’, which means subscribing to the IPO and then selling it on the first day of its launch. Buying and holding a newly-listed company would’ve resulted in a loss 56% of the time.

Problems with IPOs certainly are not exclusive to emerging markets. In the US, during 2001, after the dot.com meltdown, 23% of the 2,600 IPOs of the past five years delisted. Still the present vogue for Chinese IPOs might remind investors of that time and of one stock in particular.
 

Sina Corp is one of three Chinese Internet portals. Its IPO was on 23 April 2000, just one month after the peak of the dotcom bubble. Its initial listing price was 20. In one month it had more than doubled to 47, but sixteen months later it had fallen 97% to $1.20. After its precipitous fall, some investors actually read the fine print in the prospectus and discovered that Sina did not own a license to operate an internet business in China. Fortunately, for its investors, it has recovered and recently reached an all-time high of over 70. However, its volatility remains a stern warning to those investors with dreams of buying into the ‘can’t lose story’ of a new stock.

(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected])— William Gamble