Primary market provides more certainty, says Hongchoy

George Hongchoy of DBS say capital gains from properly-priced IPOs are more predictable than returns from stocks bought on the secondary market.
Four weeks ago, Asian equity markets saw a sharp drop that was to some extent led by Chinese stocks. While prices have partially corrected since then, markets remain jittery. Here, George Hongchoy, managing director and head of DBS Asia Capital û DBS BankÆs wholly owned investment banking arm in North Asia - gives his views on the current status of the market and what we might expect with regard to Hong Kong and China in the months ahead.

What in your view are the key reasons for the volatility in Mainland and Hong Kong markets over the past month?

The recent volatility has been due to a correction after a very significant bull run that had probably left some stocks at excessive valuations. Having said that, I think a lot of investors are looking at the current round of results announcements to see whether earnings growth, price-earnings ratios and other measurements really justify these high valuations. This will help us decide whether the correction was just a technical one, or caused by a change in fundamentals.

Are there any signs it is due to a shift in fundamentals?

It really depends on the turnout of company result announcements. Companies that are valued at 30 times forward P/Es, really have to grow at 30%-40% per annum on a consistent basis. If they cannot deliver that level of earnings growth, then obviously they require a downward adjustment to their P/E. So far, we have seen a few companies announce 50% growth in earnings for 2006, which justifies the high P/Es those companies trade at.

But in the past six months there has been a lot of liquidity-driven buying and some stocks may not deserve having their valuations pushed up. In markets where there is a strong bull run with a lot of liquidity and where every stock goes up regardless (of whether it deserves a higher valuation or not), this doesnÆt matter much, but I think we are slightly passed that stage. With more volatility, people will be looking at companies and their fundamentals more carefully and pick stocks on a bottom-up basis.

Some property stocks may find the current situation challenging. Property values have gone up so much by now that they just cannot go up much further, in any case the rate of growth will slow. As property revaluations have been recorded in the profit and loss account already, we may see a slowdown in the profit growth of some property companies.

Overall, the 2006 results of most companies are very encouraging. However, after going up so much last year, it will be a challenge for most companies to repeat the same growth rate in 2007.

Aside from earnings growth what other challenges do you foresee for the equity markets?

The external factors are more uncontrollable. The markets may be affected by any spillover effect from the US housing market, the potential of a slowdown of the US economy, and the speed of the slowdownà At the moment, no matter how fast China grows, in the near term it cannot replace the reduction in demand from a slowdown in the US. Therefore, if the US does slow down, it is quite apparent that it will have a global impact on equities and on a lot of other markets.

While Hong Kong initial public offerings have continued to see strong demand from investors despite the tumbling markets, one may suspect that the volatility will eventually start to have an impact on valuations. What is your view on this?

The general market is one of the factors affecting the IPO market. Nonetheless, even in a volatile market, if IPOs are priced well the share price will still go up - at least initially. In that respect, IPOs probably give investors more certainty of capital gains than trying to pick stocks in the market and in some ways it helps to sustain interest in new listings.
Secondly, a lot of companies still have funding needs and will continue to come to the market. If the funding needs are imminent, they have to come to market at more attractive valuations than what we have seen in the past, but I donÆt think (the volatility) will slow down the flow of companies who are interested in doing IPOs.

In terms of IPO valuations, new companies are always priced in relation to listed comparable companies in the same sector. In difficult markets where liquidity is not strong, share prices of other companies in the same sector would have come down and IPOs would have to be offered at a much larger discount to its listed comparables. This was seen in the second quarter last year when deals were still getting done (despite a sharp drop in share prices), but had to be priced more attractively than when there was a significant amount of liquidity in the market.

However, so far we havenÆt seen any signs that liquidity will dry up, baring any shocks.

Last year a lot of attention was given to the large Chinese national banks. What will be the ôthemeö for the IPO market this year?

We still see a lot of banks coming; smaller than the previous ones but they are still big banks. There is a lot of investor interest in domestic PRC consumption, retail plays and market leaders in certain industries where customers are predominantly from China. I think mining and minerals are still hot for investors and we will continue to see companies focused on consumer products, retail, the environment and property coming to the market. Manufacturing companies which exports most of their products will face challenges from a rising renminbi and higher material costs.

What is your 2007 outlook for the primary markets in Hong Kong and Asia as a whole?

In Hong Kong, volumes will still be very healthy, if you take out ICBCÆs listing in 2006. Excluding ICBC, 2005 and 2006 were pretty much the same in terms of total funds raised. We will probably achieve a similar level in 2007, but we will see more deals since deal sizes will be smaller.

Lots of Asian countries seem to have very robust economic growth that should lead to growth in investable capital. Companies will invest this both domestically and cross-border and there will probably be an increasing amount of intra-Asia merger and acquisitions. In terms of the primary markets we are seeing a strong demand for financing services as a lot of companies need funding as they grow.

DBS focuses primarily on bringing small- to medium-cap companies to the market. What is the rationale behind this?

Investors choose companies with good potential and a lot of our clients are growing companies. Investors get an opportunity to invest in these companies at a very early stage of their development and will benefit as they stay with those companies. A lot of the companies we have listed in the past few years have grown very strongly over an extended period of time.

In addition, IPO service is just one of the many different products we want to provide. We hope that by providing a whole set of products to our clients as a one-stop-shop, we can grow with them. All the big companies started out as small- or medium-cap companies when they were first listed. The wider DBS Group, which is based in Singapore, has also handled many big deals in Asia, several of which have been among the biggest and most innovative transactions. For example, we did some hotel Reits and business trusts in Singapore last year.

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