A man walks past an electronic board showing the Hong Kong stock index on March 2. A functioning capital market should offer access to a diverse range of issuers. Photo: AP
The View
by Richard Mak and Alvin M. Ho
The View
by Richard Mak and Alvin M. Ho

Why Hong Kong’s stock exchange should not raise the profit requirement for listing on its main board

  • Neither the high P/E ratio of listing applicants nor the existence of ‘shell’ companies justifies a move that could shut out many small-cap firms from a fundraising platform
  • Instead, to support these companies, the exchange should consider lowering or even removing the profit requirement
Last year Hong Kong Exchanges and Clearing consulted the public on raising the profit requirement for listing on the main board of the stock exchange. One of the key reasons for the proposed increase is to reduce the implied historical price-to-earnings (P/E) ratios of listing applicants that only just meet the minimum profit and market capitalisation requirement.

The exchange may be exaggerating the importance of historical P/E ratios. A historical P/E ratio derived from the historical profit figure is only one factor among many in investment decision-making. An issuer’s prospects are more important to the investment decision than historical P/E ratios. Therefore, drawing an arbitrary line on historical profit is of limited use, and raising the level of this arbitrary line is not an improvement.

Making this change due to to the increase in listing applications from small-cap issuers typically “in traditional industries” and with “relatively high historical P/E ratios” could be seen as the tail wagging the dog. In its consultation paper, HKEX said the increase in the market capitalisation requirement in 2018 caused the “misalignment” between the minimum market capitalisation requirement and the minimum final-year profit requirement.

Many small-cap, potential issuers would have wanted to list at a lower P/E ratio. If they had been successful, and with more of these small-cap issuers listed under a lower market capitalisation requirement, we would not have seen what HKEX notes is “an increase in listing applications from small-cap issuers that marginally met the profit requirement but had relatively high historical P/E ratios”. In some cases, companies have been forced into this position by the regulatory change of 2018.

The existence of “shell” companies in itself may not be the right focus in the context of initial public offerings. In Hong Kong, “shell” companies have come to carry negative connotations. However, in the investment community and from, say, a US perspective, a listed holding company/structure, such as a special purpose acquisition company (SPAC), has a neutral meaning. We have long been used to seeing, and many global investors are now keen to invest in, SPACS.

Moreover, the line distinguishing a “shell” company from a genuine small or medium-sized company is a fine one. Raising the bar for listing to eliminate potential “shell” listings runs the risk of collateral damage. Small and medium-sized companies with solid management and earnings potential are likely to be negatively impacted. As legitimate listing candidates, they will lose a vital fundraising channel.

How does Singapore plan to rewrite the rule book for SPACs in Asia?

The HKEX consultation paper raises the issue of whether (allegedly) “inflated valuations” genuinely reflect “expected market clearing prices” and of “suspected abusive behaviours such as manufacturing of an artificial shareholder base”. Investment management professionals would expect the exchange, regulators, sponsors and other professionals to play active roles in monitoring the capital markets as its gatekeepers and promoters. In the end, of course, it is also a case of buyer beware.

However, these concerns should not be used as the basis for disadvantaging small-cap companies. A functioning capital market should offer access to a diverse range of issuers. Large cap, small cap, new economy, old economy, hi-tech and traditional sectors, value stocks and growth stocks are ingredients of a thriving ecosystem.
Business cycles in the “new normal” environment can be volatile. Fads come and go. What we would like to see is diversity in offerings. Financial investors can help raise market efficiency by allocating resources from one segment of the economy to another. However, if the exchange only offers big cap or new economy companies, investors will have no choice but to chase the current winners. As for what happens when fads subside, to quote Berkshire Hathaway CEO Warren Buffett, “only when the tide goes out do you discover who’s been swimming naked”.
Hong Kong is a small but open economy. In recent years, there have been many start-ups, not all “new economy” companies. We are concerned that while the government, business sector, venture capital and private equity funds and the public are keen to promote start-ups, which are, by definition, small companies, the exchange is unwilling to provide them with access to a fundraising platform.

To support these start-ups or small companies that are growing their businesses, the exchange should consider lowering or even removing the profit requirement. This would just put the Hong Kong stock exchange on par with some of the more developed Western markets.

Why Hong Kong’s higher stock trading tax has solid support

We also notice that China’s Star board has not adopted a similar unofficial cap of historical P/E ratio (23 times) commonly believed to be used in the Shanghai Stock Exchange. Many investors regard this as regulatory progress, removing unnecessary barriers to the IPO process. We would expect the Hong Kong stock exchange to be at least on par with, not behind, these other exchanges.

Raising the profit requirement can be seen as regressive and as a form of financial repression in that one segment of the society is systemically disadvantaged. Too many preconceived barriers and subjective judgments will only result in a regulatory regime that consistently produces ad hoc rulings in response to prior or current faults or misalignments.

While the GEM board is cited in the consultation paper as an alternative for small-cap issuers if the profit requirement is raised, GEM is commonly not perceived as a well-functioning board. Low liquidity, long waiting time, high listing expenses and higher or equally stringent listing requirements than the main board, are just some of the problems. So while an alternative platform exists on paper, in practice, without a major revamp, issuers and their backers do not see GEM as a practical solution.

Perhaps, a holistic approach to the listing process should be considered, not a shreds-and-patches approach.

Richard Mak, CFA, is president of CFA Society Hong Kong. Alvin M. Ho, CFA, is vice-president and society secretary of CFA Society Hong Kong

David Dodwell is on vacation