Chinese Hangover Cures

By

William Gamble

August 15, 2005

Before they are weighed and sold cattle are taken to stock yards. Legend has it that they were allowed to lick salt and then permitted to drink as much water as they wanted. This entered the financial lexicon as >watered stock= also known as dilution of shares.

Stock is diluted when the company authorizes and issues more stock, usually to raise capital. More stock means the total value of the company is spread among a greater number of shares, so each share is worth less. Often large blocks of shares are, for a variety of reasons, restricted. They are not traded. Sometimes they are owned by individuals, top management or early investors, sometimes by governments in state owned companies.

It is not a dilution when the restriction ends and the stock can be traded. There has not been any increase in the number of shares. If there has been adequate disclosure, markets should be well aware of the restricted stock and discounted the value of the traded shares to reflect the total number of shares. Around the world various companies on various stock exchanges have shares that are not traded. Often a former public company still has a substantial number of shares that are owned by the government. In France, Germany, Japan, Russia and India there are numerous public companies where the majority of the shares are owned by the government. Private companies issue numerous options and share incentive programs that can be exercised often increasing the number of shares and diluting outstanding holdings.

In China, the state owns a majority of the shares in almost every listed company, with a theoretical value of $250 billion. These shares have been referred to in the press as an overhang, which is supposedly depressing the stock prices on the Shanghai exchange. But is this true?

The problem is that this ‘overhang’ of state owned shares is not unique to China. On the Indian stock exchange there are numerous companies where the state has a majority of the shares. These shares can be sold at any time. A flood of shares onto the market may by increasing supply depress demand. On the other hand, recent experience has often proved to the contrary. Often when a government announces that it is will decrease its stake in an attractive, profitable public company the shares sell for a premium. China itself provides a perfect example. There have been numerous IPOs of Chinese state owned companies usually in Hong Kong. What is always offered is a minority interest. All of these companies have substantial majority ownership by the state. The state could, at any time, reduce their interests by selling more of their holdings. Despite this ‘overhang’, these IPOs have often been several times oversubscribed.

The problems with the Chinese companies may not be with the amount of government shares. Instead it may simply be that these companies have a combination of poor returns, poor governance and poor transparency. Their value of the Shanghai and Shenzhen stock exchanges may in reality be a reflection of their true value.

Nevertheless, the government has simply assumed that the problem is government ownership and that privatization would push the value of the outstanding shares into a nose dive. To solve this problem it has proposed selling these shares, but to avoid a possible drop in price, it has proposed giving the present shareholders a Asweetener@. Shareholders of one company, Baosteel will receive a bonus of 2.2 shares for every ten shares they own. If, through connections, you were aware of this program, you might do quite well and perhaps control the company.

This scheme has rightly been attacked by one of the independent directors on the board, Weijian Shan, as a give away of taxpayer money. This is not the first time that problems occurred during a privatization.

In Russia well connected oligarches were able to gain control over large parts of Russia=s industrial sector at bargain prices, because they were able to cash in on a bent privatization. The Chinese leadership is certainly astute. I have no doubt that they learn historical lessons very well.