Buyers, Sellers and Valuations; Mispricing of Chinese shares?

The relationship between buyer and seller, conceptually, is as simple as “the buyer wants to pay as low a price as possible; the seller, receive as high a price as possible”.

The problem with this simplicity is that you may get buyer’s or seller’s remorse. Just because you bought something at a low price, does it mean that it’s low enough? For example, if you bought a Pokemon card for ￡1,000, only to later discover that its “true worth” is only ￡5.99 including tax and shipping, you would be kicking yourself. Likewise, if you sold a plot of land for ￡100,000, only to find out later that they are going to build a train station and a Waitrose next to it, you would have felt that you have been low balled.

Therefore, the exercise of using models and other tools to determine the “true” or “fair value” came into heavy use, so that post-sale regret is minimized. These valuation exercises take time and effort, but sometimes we feel that we are willing to pay this price to minimize regret.

The next problem that happens though, is when both parties cannot agree on the valuation methods used. I mean, some things are harder to model than others. One could probably say that the plot of land could be easier to value than the Pokemon card. It’s easier because:

• We humans have done it since forever;
• Therefore we know what data points to look for;
• We have developed and refined the maths to process said data to give us our estimate of the “fair value”; and
• Hence, both parties are more likely to agree on the choice of valuation method.

Pokemon cards, however, may have yet to have very formalised and publicly known methodology. So on the basis of the availability of tools and long-established public consensus, the plot of land is arguably easier to value than the Pokemon card.

But even then, these tools are just models and there are many other things that the buyer and seller can disagree on. Sure, both parties might have agreed on using tool XYZ, but both might disagree on the numbers to feed into the tool (one person who studied for an MBA described his course as “spending all these years just to figure out what discount rate to use in your cash flow model”). Also, in the end of the day, would the variation of the chosen model agree on a way to account for the probability of a train station AND a train station being built right next to it?

So while the availability of very established tools might give us good guidance, it’s still up to the arbitrary decisions of the buyer and the seller’s brains (and maybe even gut) to make the final call on the price.

And there are many arbitrary factors that influence the final execution price. One of them would be hype (e.g. the more rocket emojis I see on your due diligence report, the more convinced I am).

The other would be the relative pricing power of each party. For example, if what you wanted to buy was really unique and has limited supply (either natural or artificial limits), you the buyer would need to prepare to pay a high price for the item. The situation is to the seller’s advantage. It’s like trying to negotiate with the boss of the only mob in town - high chance of it being a very one-sided negotiation.

But if you have a larger number of sellers, the power has shifted to you the buyer. If there are multiple mobs fighting for the same turf, you might stand a better chance if you play your cards right. I mean, at the very worst, if you don’t like an offer, you could afford to just walk away.

But the ultimate question still is, how do you know that the model you’ve chosen favours or doesn’t favour your side of the deal?

Well, simply put, you could go make a comparison. If you are trying to sell your house, and your valuation model says that the price should be ￡100,000, but your neighbour just sold her very similar house for ￡200,000, perhaps it’s an indication that either:

• Your model is right, and your neighbour got lucky; or
• Your model is wrong.

But either way, it shouldn’t matter to you if you really wanted to sell the house - by diligence or by luck, either way, it’s in your every interest to obtain the highest price possible!

So here is a report that Blue Prism, a company that sells robotic process automation (RPA) technology that is listed in London, is open to considering a move to the US. The piece reports “Blue Prism chief executive and chairman Jason Kingdon said his ￡1.3 billion AI company could be worth two-to-five times more if it was listed in the US, and its share price would be far less volatile, with a deeper volume of shares and more investors to hold them there”.

He claims that the UK market doesn’t know how to value tech companies. He said,“... this is what we don’t get [in the UK]. That ability to be able to look at a tech company and judge a good one from a bad one.”

Sure, there’s a whole debate whether US stocks are overvalued and that UK’s stocks are just temporarily undervalued since the Brexit vote. But even if you don’t agree with the valuations of tech companies in the US, firms like Blue Prism possibly have these two advantages:

• Its product offering is fairly new and unique (there are more competitors like it today than it did a few years back, but it’s still a fairly unique product offering)
• It can choose to walk away from its London listing and move to the US. There are just more people willing to bid higher than there are people who would bid lower there. So even if you won’t bid for it, there are probably two or three more ready to push you out of the queue to the till.

Sure, if you’re a buyer, it’s in your interest to not overpay for stuff. And sure, you might also argue that despite your vested interest, the models that you employ claim that things in the US are empirically and objectively overvalued by historical standards.

But also keep in mind that it’s the CEO’s interest and fiduciary duty to her shareholders to maximise whatever value she can get. And if that means moving to a market where the highest bidders trade, all while also moving away from a market that is probably overcast for the past four years by the uncertainties of Brexit, how can you blame her?

And do you know who else has started selling his wares in the US markets? That’s right, it’s the former CEO of the London Stock Exchange Group, Xavier Rolet, as Quartz reports. Rolet has his very own SPAC, raising $345m on the New York Stock Exchange. “Europe simply does not have the equity capital markets that understand and price innovation appropriately,” Rolet said. 

So, what is the UK (and Europe) to do? Would it stick to its guns and argue that everything would play out alright in the long run when “the tech bubble pops like it did in the Dotcom Bubble”? Or would it pivot?

Mispricing of Chinese shares?

If you are so inclined to invest in companies based in China, you could. Just not as easily as you could with shares listed in the US.

The shares that are locally traded in China aren’t necessarily openly tradable to non-Chinese persons or entities. They do trade, just that we can’t readily trade them right off the bat. These local shares are called “A-shares”.

But necessity is the mother of invention - businesses in China are still businesses afterall, and they do need access to capital. And people outside of China have excess capital to invest. The result? Some Chinese companies choose to:

• Issue “H-shares” that are traded in Hong Kong and are readily tradable by anyone; or
• They would hire banks to wrap these A-shares up into American Depository Receipts (ADRs), which then can be easily traded on US exchanges (or even over the counter). This is like the multipack deals for soft drinks or crisps, where each A-share is worth 50 cents, so the bank wraps 10 (or whatever convenient number) of these up into one ADR so that one unit trades for $5. (Why is the A-share worth so little in dollars in the first place? I don’t know, but the minimum trading quantity in Chinese exchanges is 100 units, so to make them accessible, maybe that’s why the unit price is so low?)

So for the purposes of this write up, there are three markets that are selling essentially the same thing - equity in a Chinese-domiciled business.

One would think that these units would trade at near, if not at, equal values. But here’s the kicker - they don’t. If anything, from data of companies with shares traded in two or all of these markets, the locally traded A-shares trade at a higher price than the equivalent H-shares or ADRs:

Source: People’s Bank of China

Why is this so? So this working paper from the People’s Bank of China did some statistical analysis (the paper is quite comprehensive), and they found that the main factors they drive this spread are:

• “First, dividend ratio is the most decisive in premium determination, meaning that international investors pay most attention to fundamentals” (“Higher dividend yields are attractive to US investors.”);
• “Second, market sentiment is incrementally more important for explaining AH premium than A-ADR premium, reflecting the fact that irrational cross-market herding behavior is stronger between the A and H markets than between the A and ADR markets.”;
• “Third, over the observed period overseas investors are more sensitive to China’s financial market openness, and more adaptive to RMB foreign exchange rate volatility”

Basically (my opinions),

• Yields outside of China are very low, so the moment something that pays a large dividend pops up, investors buy it;
• It’s largely about the power of hype (and the number of rocket emojis);
• The concerns of “it’s a foreign company”; and
• It’s harder to short shares in China.

And now with the US’s “Holding Foreign Companies Accountable Act” (a very bipartisan effort to vote this in. Here’s the relevant Democrat-led House of Representatives transcript recording a two-thirds majority) threatening the listing status of the ADRs of Chinese companies, it may be possible that the demand that was there for ADRs would be very much shifted to A- and H-shares, as funds like Temasek and Baillie Gifford have started exchanging their ADRs for on-shore shares. I mean, those pension plans need to be funded somehow. And if yield’s to be found in China, that’s where the money would go.

Originally published on my Substack at https://aaronleong.substack.com/p/buyers-sellers-and-valuations-mispricing

Source: Old shiba memes circulated on the internet.

Source: Old cat memes circulated on the internet

Source: Yes, old memes.