The latest addition to China’s capital markets has left investors with a bad taste in their mouths, as shares dropped on their debut just days after traders raced to snap up these offerings.

Two-thirds of the 32 stocks listed on the so-called Premium New Third Board, a Beijing-based trading venue for small firms, fell on Monday. That shocked investors, who in recent decades have become conditioned to shares surging on their first day of trading regardless of fundamentals.

“I am very disappointed about [the first day’s] performance,” said Zhou Yunnan, founder of Beijing-based fund Nanshan Investment, which owns PNTB-listed stocks. “It has undermined our confidence in the market.”

Investors had big hopes for PNTB as demand for shares in initial public offerings outstripped supply by more than 100 times. That was despite allegations of questionable financials among some of these companies.

One PNTB company, Shanghai-based software maker I2Finance, was denied a Shenzhen IPO last year after regulators questioned its profit margins. The regulator also alleged that some of I2Finance’s workers provided services to firms controlled by its founder, breaking rules on related-party transactions.

Welltrans O & E Co, a Wuhan-based maker of video surveillance products, was allowed to list on PNTB after regulators in 2018 rejected a separate IPO request due to unusually high accounts receivable compared to revenue.

Those issues did not initially put off investors. I2Finance’s IPO was 2,339 times oversubscribed even though the company still has not addressed concerns surrounding its books.

“There is no need to look at the fundamentals,” said Zhang Chi, a Beijing-based fund manager who was unable to secure an allocation to the company’s IPO prior to the first day of trading. I2Finance’s shares rose 6 per cent on their debut while Welltrans O & E Co fell 9.8 per cent.

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China’s retail investors — an influential force in the country’s markets — have long been enthusiastic backers of IPOs.

Following a secondary listing in Shanghai earlier in July, shares in Chinese chipmaker SMIC surged 246 per cent on their first day of trading. Stocks listed on the Star Market, billed as the country’s answer to the Nasdaq, rocketed by as much as 520 per cent on their debut a year ago.

Public records show that more than 95 per cent of new listings in Shanghai and Shenzhen over the past two decades have jumped on their first day of trading. “There is no easier way to profit from China’s stock market than investing in an IPO,” said Wang Yihe, a Shanghai-based fund manager, ahead of the new market’s launch.

Chinese traders have also been emboldened by a recent rally in the country’s main stock markets rooted in the country’s economic recovery from Covid-19.

“New share offerings are one of the safest and most profitable investments for Chinese retail stock buyers,” added Mr Wang. “If the strategy stops working, investors will exit the market, making future IPOs difficult.”

The tradition of red-hot trading debuts is due partly to a government policy that forces companies to under price the shares sold during an IPO in order to lure retail investors. That results in an influx of buying orders from traders who believe they are getting the shares at a bargain price.

While keeping valuations artificially low at IPO has historically proved a winning strategy with investors, critics say it has made China’s markets — the world’s second-largest by total capitalisation — inefficient and prone to volatility.

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Regulators had originally earmarked the PNTB as a testing ground for reforms. The market technically has no limit on the valuations at which companies can sell their shares during an IPO. But investors pointed out that some businesses still lowballed their stock price in a bid to ensure a day-one surge.

That strategy appears to have backfired this time. Shares of most PNTB-listed stocks took off during the first 10 minutes of trading before reversing course. Analysts said it was likely institutional investors had tried to offload their shares to retail traders en masse, driving down prices.

While it is early days, investors say PNTB’s reputation may already be tarnished. “The market will become a failure if stocks don’t gain 50 per cent on the first day of trading,” said Mr Zhou of Nanshan Investment.

PNTB’s sluggish performance has also called into question Beijing’s efforts to encourage small businesses hit by coronavirus to shore up their balance sheets by selling equity.

Line chart of Postal Savings Bank of China's SME Operating Index (reading below 50 indicates worsening business conditions) showing Coronavirus slams China's small businesses

The pandemic has dealt a heavy blow to China’s small firms — a significant employer in the world’s second-biggest economy — which have been slammed by government-imposed lockdowns. Authorities have responded by relaxing controls on equity financing to help then reinforce their balance sheets. PNTB has lower profit and revenue requirements than China’s main stock exchanges in Shanghai and Shenzhen.

“The government thinks it would be easier for troubled firms to sell shares by offering a discount,” said Zhuang Bo, an economist at TS Lombard. “But the poor performance of PNTB suggests these companies are not worth that much even after offering a discount.”

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Additional reporting by Xinning Liu in Beijing

Via Financial Times