Capital Pulse

Apr 15, 2020 | Articles, Global Markets Update

SEARCHING FOR THE LIGHT AT THE END OF THE TUNNEL

For six months ended 31 March 2020, there were 212 applications for listing on the Hong Kong Stock Exchange compared to 255 applications in 2019 and 243 in 2018 based on their first posting date. However, since January 2020, application for listing activity has slowed markedly with only 57 new applications for the first quarter, which is almost a 50% decline in new applications compared to the same quarter in 2018 and 2019. There were 33 approval-in-principle outstanding with 28 approval-in-principle granted during the quarter. 69 applications lapsed but 38 applicants renewed their listing applications representing a 55% renewal rate. Four applications were withdrawn and 139 applications remain in the pipeline.

During the quarter, 40 new companies listed on the stock exchange and two companies were transferred from the Hong Kong GEM Board to the main board under the grandfathering arrangements. This compares to 38 companies in 2019 and 36 companies in 2018 for the same quarter. However, funds raised were significantly lower averaging HK$349 million per IPO which was approximately 40% lower than 2019 and 50% lower than 2018.

Given that measures to contain Covid-19 only started during the quarter, it appears that the slowdown in fund raising activity was well underway since mid-late 2019 given the time required for the raising equity capital, if not for Alibaba’s secondary listing on and Budweiser APAC IPO. Unfortunately, the slowdown is expected to continue given lower market valuations even though it has been reported in the media of an expected mega-IPO by the end of this year. Unlike traders where day-to-day market fluctuations matters, equity capital raising require significantly amount more time making current market conditions less relevant for companies planning such an undertaking.

THE MORE THINGS CHANGE, THE MORE THEY STAY THE SAME

Every market crisis may have a different root cause, but the market reaction to each crisis may not be so dissimilar. Even in the post GFC a low interest rate environment, we still witness the classic decade long cycle between major financial crisis. Although we have experienced average weekly swings in the Hang Seng Index (“HSI”) of over 800 points per week since the beginning of the year, it would come as no surprise that there will be more volatile markets in the foreseeable future.

Figure 1: Hang Seng Index (Weekly)

Apart from the GFC when the HSI fell almost 20,000 points over 16 months, the last significant correction was in 2015-2016 during the China stock market crisis when the HSI fell 10,000 points over 9 months. However the long-term picture indicates that we are now experiencing the somewhat overdue major correction in this decade long market cycle.

Figure 2: Covid-19 versus SARS market experience

Figure 3: Covid-19 versus GFC market experience 

Whilst not suggesting that history is expected to repeat itself, there are a couple of points that history could serve as a guide. Apart from much greater volatility, the market tends to require a longer period to digest the magnitude and economic consequences of each crisis. There is one major difference between SARS and Covid-19, namely SARS predominately affected the Greater China region whereas Covid-19 has global footprint, and the associated economic problems are expected to be more pronounced and perhaps prolonged. Therefore it appears the GFC market experience might be a better proxy than SARs.

Volatility, volatility and more volatility

Figure 4: Covid-19 versus SARS volatility experience

Figure 5: Covid-19 versus GFC volatility experience

The behaviour of the HSI Volatility Index further demonstrates the parallels between the current market environment and the GFC rather than SARS where less volatility in the equity markets. If the GFC experience is any guide, we are nowhere close to the end of the tunnel. Investors should be wary of V-shape, W-shape or U-shape economic predictions given the extreme uncertainty.

The key takeaway is companies need to manage their capital positions carefully during the next few quarters as cost of equity will remain expensive and there may be little appetite for capital issuance in general. Those companies who would like deploy excess cash to take advantage investment opportunities in current market conditions should be aware that something that looks cheap can become (a lot) cheaper. Such investors need to stay vigilant in filtering out the noise in the market in their investment decisions.

NOTABLE REGULATORY INITIATIVES DURING THE QUARTER

Consultation on Corporate Weighted Voting Rights

• Companies that are considered innovative by regulators have an ownership and business operating environment which is crucial for the success of the business that necessitates super-voting shares or weighted voting rights;
• It will affect the valuation of such company by stock analysts; and
• The competition allows it, if the stock exchange does not follow suit, it will lose business.

However, what about minority shareholder protection under the listing rules? The proposed protection measures include limiting the life of corporate weighted voting rights to ten years and the corporate weighted voting rights beneficiary must actively drive the business of the listing applicant. Also, size matters as the market capitalisation of the beneficiary entity of the weighted voting rights must be at least HK$200 billion (approximately US$25 billion) and the market capitalisation of the listing applicant must not account for more than 30% of the market capitalisation of such entity.

Guidance and training on Environmental, Social and Governance

The term Environmental Social Governance (“ESG”) was made popular from a 2005 in a joint study by financial institutions and supported by the Swiss government on the back of an invitation of the then UN General Secretary Kofi Annan to develop guidelines and recommendations on integrating environmental, social and corporate governance issues in the financial services. It draws up qualitative factors that investors should consider to judge the sustainability of a business such as:

Table 1: ESG Factors

In summary, the emphasis is on the listed company to explain its ESG policy and approach to the investing public rather than to focus on specific areas. It leaves a free-hand to the company to explain the material ESG risks of the business in the ESG report following a policy of “comply or explain”, i.e. if an ESG risk is not relevant or material to the company then it can explain why such disclosure is unnecessary. This is a positive step towards establishing a minimum standard of reporting to investors, especially since ESG funds a more recent trend in asset management products and incorporation into investment processes in the Asia Pacific region as opposed to the US and European counterparts. The Global Reporting Initiative or GRI standards is a reference for a deeper discussion of ESG issues.

OTHER HOUSEKEEPING MATTERS

Guidance provided to companies due to Covid-19

The regulators issued a Joint guidance on results announcement in light of the travel restrictions relating to Covid-19 on 4th February 2020 and 16th March 2020, and an FAQ on this topic on 28th February 2020. Listed companies are requested to consult with the Exchange on their ability to meeting their financial results announcement obligations in light of the Covid-19 and are required to publish material financial information to maintain their trading status. Listed companies may defer the publication of its annual reports due on 31st March 2020 and 30th April 2020 initially for up to 60 days from the date of the 16th March 2020 joint guidance statement if the company has published, on or before 31st March 2020 financial information specified therein.

Streamlining of Guidance Letters and FAQs relating to listing matters

The listing department has updated their guidance to the market pertaining to issues relating to controlling shareholders, mineral applicant companies and distributorship business. Thus far, there has been three new guidance letters, 20 updates to guidance material to the market and 54 withdrawal of the same as part of this streamlining initiative.

The update to controlling shareholder guidance letter is a minor housekeeping item to incorporate the principle that the ownership continuity and control requirement applies to the single largest shareholder when an applicant does not have a controlling shareholder, which was previously published in FAQ Series 1 No.16 that has been withdrawn.

Similarly, the update to the minerals companies guidance letter draws principles from eight guidance materials that have been withdrawn pertaining to disclosures in the prospectus and competent persons report such as conditions for exclusion of assets in such report but supplemented by alternative disclosure in the prospectus.

There have been further clarifications provided in the updated guidance letter to applicants that are distributorship businesses on issues of which parties are considered distributors and sub-distributors, and risk disclosure requirements on cannibalisation and control over sub-distributors on the business model.

Odyssey Corporate Advisory is a boutique corporate advisor providing independent and impartial investment and capital markets consultancy services catered for your circumstances and preferences. Corporate Advisory is a division of Odyssey Asset Management Ltd, a Type 1, 4 and 9 SFC licensed company and subsidiary of the Odyssey Group. If you have any enquiries, please contact:

Kuan Yu Oh
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Mobile: +852 6971-7989
Email: kuanyu.oh@odysseycapital-group.com

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This publication is for informational purposes only and does not address the circumstances of any particular individual or entity. It does not constitute financial advice and should not be used as such. You should seek a duly licensed professional for investment advice. For more information about please see our Disclaimer.

Market Update: April 2020

Apr 9, 2020 | Articles, Global Markets Update

Outlook

Despite heightened worries about the impact of the virus on the US, we believe data is consistent with our base case (60% probability) in which new virus cases peak by mid-April in Europe and the US; the most severe restrictions are lifted from May; and a coordinated monetary and fiscal response allows for a V-shaped recovery to take hold from the third quarter of this year with rapid acceleration in the fourth quarter. UBS “expects to see evidence by mid-month that the US is starting to bend the curve. In Europe, we see more compelling evidence that governments in Italy, Germany, France, and Spain are bending the curve now”.

Market developments over the coming weeks will hinge on four key factors: First, whether we see further evidence that containment measures are slowing infection rates. Second, whether announced government stimulus measures are actually succeeding in preventing job losses and bankruptcies. If governments can do this, then we could expect a relatively swift recovery in demand when economies reopen ie to ‘preserve capacity’. Thirdly central banks’ measures to prevent a liquidity crisis work in the next 2-3 months and thus stop a solvency crisis developing that might result in a severer recession or even a depression (and a far worse public healthcare crisis than this virus). Lastly evidence of a slowdown in infections and lower morbidity rates, as the use of better therapeutics make treatment more effective, should reduce fear and pessimism.

We believe markets are past the peak in panic seen in mid-March but very poor macro data, and the rising death toll, may mean we are not yet at maximum pessimism and that a retest of the 23rd March lows at 2,237 on SPX and 10year US Treasury yield at 31bps are quite possible and this fits with previous corrections needing markets to form a ‘double-bottom’. We would look to deploy cash and reposition defensive assets, as some of our Alternatives, into riskier assets into such declines.

With equities and lower quality bonds offering the most attractive valuations since 2016, higher risk investors can put excess cash to work via an averaging-in strategy. In addition, investors can buy gold as increasingly the only genuine ‘safe haven’ asset. We see opportunities in Asian equities  that are relatively cheap and whose earnings impact from the virus is likely to be relatively limited, as well as  quality stocks globally, that can protect dividend payments, that should be resilient.

We think credit is closer to pricing in our downside scenario than equities, and US investment grade, US high yield, and US dollar-denominated emerging market sovereign bonds all offer attractive opportunities after selling-off to levels last seen in the GFC. To put this into perspective US HY spreads over USTs blew-out by over 1,000bps, similar to the fall in GFC, which implies a 50% default rate over the next five years whereas SPX, using our estimates for ‘normalised’ earnings in FY21, is trading at just under 15x vs. the long-term 16.6x average and on over 2x PBV that is decent value but hardly a bargain. The explosive rally in equity markets late March means they are closer to pricing in our base case scenario and the need to be more selective. Equities main attraction is they look cheap relative to high quality bonds and offer better income too.

When to Downgrade the Lockdown?

A real concern is that unless economic activity is restored relatively quickly, companies with much reduced, or no, revenues will face a solvency issue and this risk is made worse by a record high debt to equity level that could lead to a Depression via a horrific credit crisis – surely a danger most governments would seek to avoid? We might not be able to contain the virus, but we can avoid triggering a solvency/credit crisis that may have other enormous public health consequences.

Perspective: Fullerton’s “letter”

We will like to end this off with a speech from former Capital Group Chairman Jim Fullerton. He delivered this speech in Nov 1974 amid a prolonged bear market and provides us with a historical perspective, and some optimism, in a market environment like what we are in today.

Figure 1: Stock markets’ resilience            Source: Capital Group

The speech is as follows:

“Courage! We have been here before”: One significant reason why there is such an extreme degree of bearishness, pessimism, bewildering confusion, and sheer terror in the minds of brokers and investors alike right now, is that most people today have nothing in their own experience that they can relate to, which is similar to this market decline. My message to you, therefore, is: Courage! We have been here before. Bear markets have lasted this long before. Well-managed mutual funds have gone down this much before. And shareholders in those funds and we the industry survived and prospered.

I don’t know if we have seen the absolute bottom of this prolonged bear market, (although I think we’ve seen the lows for a lot of individual stocks). Each economic, market and financial crisis is different from previous ones. But in their very difference, there is commonality. Namely, each crisis is characterized by its own new set of nonrecurring factors, its own set of apparently insoluble problems and its own set of apparently logical reasons for well-founded pessimism about the future.

Today there are thoughtful, experienced, respected economists, bankers, investors and businessmen who can give you well-reasoned, logical, documented arguments why this bear market is different; why this time the economic problems are different; why this time things are going to get worse — and hence, why this is not a good time to invest in common stocks, even though they may appear low. Today people are saying: “There are so many bewildering uncertainties, and so many enormous problems still facing us — both long and short term — that there is no hope for more than an occasional rally until some of these uncertainties are cleared up. This is a whole new ballgame.”

A whole new ballgame: In 1942 everybody knew it was a whole new ballgame. And it was. Uncertainties? We were all in a war that we were losing. The Germans had overrun France. The British had been thrown out of Dunkirk. The Pacific Fleet had been disastrously crippled at Pearl Harbor. We had surrendered Bataan, and the British had surrendered Singapore. In April 1942, inflation was rampant.

Today almost every financial journal or investment letter carries a list of reasons why investors are standing on the sidelines. They usually include (1) continued inflation; (2) illiquidity in the banking system; (3) shortage of energy; (4) possibility of further outbreak of hostilities in the Middle East; and (5) high interest rates. These are serious problems.

But on Saturday, April 11, 1942, The Wall Street Journal stated: “Brokers are certain that among the factors that are depressing potential investors are, (1) widening defeats of the United Nations; (2) a new German drive on Libya; (3) doubts concerning Russia’s ability to hold when the Germans get ready for a full-dress attack; (4) the ocean transport situation with the United Nations, which has become more critical; and (5) Washington is again considering either more drastic rationing with price fixing or still higher taxes as a means of filling the ‘inflationary gap’ between increased public buying power and the diminishing supply of consumer goods.” (Virtually all of these concerns were realized and got worse.)

On the same day, discussing the slow price erosion of many groups of stocks, a leading stock market commentator said: “The market remains in the dark as to just what it has to discount. And as yet, signs are still lacking that the market has reached permanently solid ground for a sustained reversal.” Yet on April 28, 1942, in that gloomy environment, in the midst of a war we were losing, faced with excess profits taxes and wage and price controls, shortages of gasoline and rubber and other crucial materials, and with the virtual certainty in the minds of everyone that once the war was over we’d face a post-war depression in that environment, the market turned around.

A return to reality: What turned the market around in April of 1942? Simply a return to reality. Simply a slow but growing recognition that despite all the bad news, despite all the gloomy outlook, the United States was going to survive, that strongly financed, well-managed U.S. corporations were going to survive also. The reality was that those companies were far more valuable than the prices of their stocks indicated. So, on Wednesday, April 29, 1942, for no apparent visible reason, investors again began to recognize reality.

The Dow Jones Industrial Average is not reality. Reality is not price-to-earnings ratios and technical market studies. Symbols on the tape are not the real world. In the real world, companies create wealth. Stock certificates don’t. Stock certificates are simply proxies for reality.

Now I’d like to close with this: “Some people say they want to wait for a clearer view of the future. But when the future is again clear, the present bargains will have vanished. In fact, does anyone think that today’s prices will prevail once full confidence has been restored?” That comment was made 42 years ago by Dean Witter in May of 1932 — only a few weeks before the end of the worst bear market in history. Have courage! We have been here before — and we’ve survived and prospered.

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