IPO GAME: Winning from an IPO in China is like winning at the lottery, where investors are guaranteed a high income in the secondary market

Zijin Mining Group Co. Ltd. (SH.601899) initial public offering (IPO) was a nightmare for the current IPO system.

On April 25, the first day of its debut on the Shanghai Securities Exchange (SSE), Zijin Mining's share price soared as high as 21.6 yuan ($3.1) from a mark of 10 yuan ($1.5) in just one hour during afternoon trading time. The SSE halted its trading activity at 2:25 p.m. and resumed it again half an hour later. In the five minutes between 2:55 p.m. and 3 p.m., Zijin's share price plummeted and closed at 13.92 yuan ($2). The price continued to drop in the following days and fell to 10.51 yuan ($1.5) on April 30.

More surprisingly, the paper value of Zijin shares was mere 0.1 yuan ($0.014). If the paper value were counted at one yuan ($0.14) per share as usual, the IPO price would be as high as 71.30 yuan ($10.2)-the highest IPO price in the mainland stock market. The corresponding price/earning (P/E) ratio was 79.4 on the first trading day. On the same day, Zijin shares traded on the Hong Kong stock market closed at HK$ 7.61, almost half of the price in the mainland. Furthermore, the 92.53-percent turnover rate exposed the malicious motives behind the biggest movers of the shares.

As a matter of fact, in the mainland A-share markets, stock price surges on the first trading day have become a tradition. Behind the curtain are institutional investors and those who control large sums of money. They make use of the individual investors' ignorance and entrap them with a high price. This kind of activity not only hurts individual investors but also forges a very negative impact on the market.

This phenomenon has already caught the attention of the regulatory department. Wang Lin, deputy director in charge of IPO supervision at the China Securities Regulatory Commission (CSRC), stated that CSRC was recently researching how to improve the IPO system. He pointed out the root cause for the IPO zeal was the large price gap between IPO price and the price traded on the secondary market. It means the holders of IPO can be guaranteed high income at low risk. Wang suggested the fundamental method to resolve the problem was to narrow the price gap on the primary market and the secondary market.

The increased ability for individual investors to win IPO shares is being pushed. Wang said this was under consideration by the CSRC. According to him, the CSRC is holding meetings and discussing how to relatively reduce the chances for institutional investors to take large portions of IPOs and to raise small and medium-sized investors' chances of winning IPO gains.

Average investor loses out

Winning at the IPO game has become a new strategy for many stock investors. Compared with the secondary market, the cost for getting in on IPOs is low with few risks. Judging by the stock performance on the A-share markets, it is least possible that the stock price falls behind the IPO price. According to figures from the SSE, the new shares grew an average 83 percent on the first trading day in 2006, and reached as high as 140 percent in 2007.

This phenomenon has lured many investors to believe that as long as they are successful in applying for IPO, they could get very desirable income from trading on the secondary market. The P/E ratio could surge to tens of thousands. In developed countries, however, it is very common that the share price on the first trading day falls behind the IPO price.

But for many individual investors, it is not easy to get the chance to actually profit from an IPO. According to the current new share offering system, making a gain on an IPO is closely related to the amount of money. Xin Chaobin, a money manager with Bank of Communications, estimated that when an investor holds over 15 million yuan ($2.14 million), he can be 100 percent sure to get a proportion of the IPO. It is an advantage of scale. Therefore, the chance for individual investors to secure a profit is very low.

Individual investors cannot compete with the mainstream forces such as institutional investors. The latter will raise the price of IPO shares to a very high level to attract the interest of individual investors, who will probably be lured to buy those shares. After seeing a large number of investors taking the bait, the institutional investors will seize the chance to sell their IPO shares. That is why many new shares surge on the first trading day but go down on the following days.

Take PetroChina Co. Ltd. (SH. 601857)-the most weighted stock on the A-share market-for example. Its IPO attracted 3.38 trillion yuan ($483 billion), but the number of accounts applying for PetroChina IPO was only 4.08 million. Hence individual investors who were interested in PetroChina had to buy its shares through the secondary market. On April 30, the share price of PetroChina plunged two thirds to 18.07 yuan ($2.58) from the highest point of 48.62 yuan ($7) on the first trading day. Individual investors who bought the PetroChina shares at a high price complained of the irresponsible actions of institutional investors.

Meanwhile, whenever there is a new IPO in the market, huge sums of money are yanked out of the secondary market to compete for purchasing IPO shares in the primary market. After the frozen money is freed, part of the sum will flow back to the secondary market. Such movements of money will cause drastic price fluctuations of shares already traded in the secondary market. Furthermore, in order to raise the chances of winning on an IPO, some institutional investors turn to bank loans, leading to abnormal movements of capital between financial institutions and the banks. For instance, when institutional investors applied for purchasing the PetroChina IPO, the seven-day interbank repo rate rose from 2.5 percent to 15 percent, the highest in history.

The CSRC proposal to increase individual investors' chances to gain while reduce the institutional investors' chances of winning the lot for an IPO is the key to resolving the problem. Yang Tao, assistant researcher at the Institute of Finance and Banking under the Chinese Academy of Social Sciences, believes the proposal, if put into practice, would greatly ease the current problems and calm the drastic price fluctuations to some extent.

Optimizing the price inquiry system

The fundamental motive for purchasing IPO shares is to seize the huge price margin of IPO price and the price traded in the secondary market.

Gui Haoming, research director with Shenyin Wanguo Securities Co. Ltd., contended, "The price should indeed be decided by the market. If the market buys the company, it is no surprise the share price of the company will surge. However, if each IPO has the same effect, it means the IPO inquiry system has flaws."

According to the current IPO price inquiry system, all companies with an IPO ambition must inquire with investors about the IPO price. The institutional investors, who hold large sums of money, will choose to pick the highest IPO price possible to gain favor of IPO companies. This mentality will push high P/E ratio. If the IPO price and the IPO P/E ratio are set far higher than the reasonable range, prices in the secondary market will be pushed further higher.

After the IPO mechanism was resumed in 2006, the P/E ratio in the primary market was pushed higher and higher along with bullish market development. The average P/E ratio of IPO shares is around 30. The P/E ratio of some companies, like Ping An of China Co. Ltd. and China COSCO Co. Ltd., could reach 80 or 100.

In Hong Kong stock market, the IPO price of PetroChina was a bit more than HK$1, but its IPO in the mainland was priced at 16.7 yuan ($2.4). The PetroChina P/E ratio in the mainland was over 22, while the average ratio of similar international oil companies was from 12 to 15. Although the robust development of the Chinese economy can sustain such a high P/E ratio, it is still abnormal compared with mature markets.

Shang Fulin, Chairman of the CSRC, recently emphasized that price marketization is a trend. In the future, Shang said the CSRC would strengthen supervision over price inquiries, raise the chances for small and individual investors to gain from IPOs, and check speculation on IPOs.

Perfecting the sponsor system is also part of the task for the supervisory department. Sponsors are relatively powerful in international financial markets. They can readjust the IPO price of a company after investors raise doubts about an IPO price. But in the mainland stock markets, sponsors are in a relatively weak position and are incapable of calling the shots by deciding IPO prices. To gain the biggest interest possible, companies with IPOs prefer to choose sponsors which give high IPO prices.

Shang said the CSRC would enact relevant regulations guiding the sponsor system so that company IPOs can be launched in a rational manner.