China's Sci-Tech Board: Hope Or Hype?

What the new Nasdaq-Style exchange could mean for investors.

Jason Zhu

Jason Zhu Director of Portfolio Management—China Equities,Franklin Templeton Emerging Markets Equity

Key takeaways

  • China will be launching a Nasdaq-style stock market for technology and research-driven companies to list and raise capital. We believe this upcoming science and technology innovation board is of strategic importance to China. It could rev up China’s emergence as a research powerhouse while the country battles accusations of intellectual property theft and technology sanctions from the United States.
  • The sci-tech board looks set to broaden companies’ access to private capital. It is also a test case for capital market reforms—changes to the initial public offering (IPO) and trading mechanisms could be rolled out to China’s main boards if they succeed. Moreover, the board could push China’s industries up the value chain, by channeling funds to homegrown businesses developing innovative capabilities.
  • The board has its detractors. For many, worries of speculation loom large. However, we believe China has gleaned lessons from the past, and regulators have adopted measures to defend market stability.
  • As fundamental investors, we will be watching at least two key factors—the quality of companies listed and their valuations. The board could help emerging companies grow into industry champions. But identifying companies with the right potential would require investors to have strong research skills. Meanwhile, short-term valuations could be choppy, even if extreme froth is curbed. Until we can identify compelling investment opportunities, we are likely to stay on the sidelines.

Big ambitions

In November last year, Chinese President Xi Jinping unveiled plans to launch a science and technology innovation board on the Shanghai Stock Exchange. The board promises to accelerate innovation in China, by offering a dedicated platform for technology and research-driven companies to list and raise capital. Market observers have been quick to draw parallels between the board and the United States’ Nasdaq.

We are positive about the move. We believe the sci-tech board is of strategic importance to China as it presses on with economic restructuring. In particular, the board could rev up the country’s emergence as a research powerhouse while it battles US accusations of intellectual property theft and technology sanctions. Despite widespread perceptions of China as a skilled imitator, it has begun to lead as an innovator in several areas. Consider how it topped the world with a 43.6% share of global patent filings in 2017—more than double the United States’ 19.2% share, or how its research and development spending has risen to 2.13% of its gross domestic product, compared with an estimated 1.96% for the European Union.1 In fields where China needs to catch up, the board could bring in funding and give it a vital leg up.

Overall, we see the sci-tech board making an impact in several ways.

1) Broaden access to private capital 

Equity markets are central to capitalism—they link companies hungry for cash to investors seeking returns. China’s liberalization in the past few decades has been accompanied by the blossoming of its stock markets, which helped fuel the rise of “old economy” giants in areas such as energy, mining, property and banking amid the country’s investment-led growth. Most of these companies had proven themselves with established business models before they could list.

But China’s economic priorities have evolved. So too, should its financial markets. As China pins mounting hopes on innovation to drive higher-quality growth and technological breakthroughs, we think the sci-tech board’s creation is timely. It would enable not just high-tech start-ups to raise cash, but also venture capital and private equity funds to exit their investments and redeploy capital. Altogether, the board could encourage private capital investments in the technology scene.

The implications go further. A stock market that better serves China’s real economy can potentially improve capital allocation in a country that has been criticized for handing out state subsidies and other forms of aid. We see the sci-tech board creating room for the government to reduce support, which should strengthen the economy’s efficiency and longer-term resilience.

2) Deepen capital market reforms

China’s equity markets, though massive, remain uninviting for some investors and high-quality companies looking to list. Among their concerns are strict practices that rein in market forces and impede efficiency. These include an approval-based system for IPOs, a profitability requirement for listing candidates, an unofficial but widely observed cap on IPO valuations and daily price limits for stocks.

"Beyond pulling in capital, the board is likely to inject dynamism into the financial ecosystem, whether by promoting venture capital activity, or by spurring the launch of mutual funds targeting investments in technology firms."

China has pledged to reform its capital markets and we view the sci-tech board as a pivotal testing ground. It would mark several “firsts” in the country as it shifts to a registration-based IPO system and accepts unprofitable companies. It would also waive the implicit IPO valuation cap and loosen daily price limits. We expect these features to give market forces greater sway and make IPOs faster and more transparent. Some of these features could also be applied to other domestic exchanges in the future.

The sci-tech board looks set to deepen China’s capital market reforms

Exhibit 1: Select differences between major A-share exchanges and the sci-tech board

Exhibit 1: Select differences between major A-share exchanges and the sci-tech board

Sources: March 1, 2019. “Special Provisions of Shanghai Stock Exchange on Trading of Stocks on the Sci-Tech Innovation Board.” Shanghai Stock Exchange; April 30, 2019. “Rules Governing the Listing of Stocks on the Science and Technology Innovation Board of Shanghai Stock Exchange (Revised in 2019).” Shanghai Stock Exchange; Lee, G. June 2, 2018. “ China’s moves to cap first-day IPO gains prove to be a winning ticket for issuers and investors.” South China Morning Post; Ren, D. December 7, 2018. “China takes a step closer to unveiling a new stock market inspired by Nasdaq.” South China Morning Post.

We believe the board reflects China’s commitment to making its capital markets more open and competitive. For Shanghai especially, the board could aid its bid to become a global financial center. Beyond pulling in capital, the board is likely to inject dynamism into the financial ecosystem, whether by promoting venture capital activity, or by spurring the launch of mutual funds targeting investments in technology firms. A successful board could even entice Chinese companies listed overseas to also list onshore.

3) Promote industry upgrade

We view the sci-tech board as a critical prong of China’s plan to move its industries up the value chain. Its economic rebalancing and technological survival would depend heavily on its ongoing transition from a cheap maker of low-end goods to a developer of high-tech and high-margin products.

In the sci-tech board’s focus are strategic industries such as semiconductors, big data, advanced equipment, new energy and biomedicine. We note that China lags the West in some of these areas, and the infusion of private capital could give it a boost in catching up and building a lead. For companies with convincing strengths in innovation, the board is a prime channel of financing that could ramp up their growth and help them—and China—compete on a global scale.

Flourish or flail?

The sci-tech board has its detractors. Worries of a rapid boom and bust loom especially large. Chinese investors have historically shown outsized interest in new bourses and listings, driven in part by confidence in the IPO approval process and a belief that capped IPO valuations spawn easy returns later. ChiNext in Shenzhen, for example, had surged on investor exuberance shortly after its debut in 2009, only to sink when interest waned. Understandably, market excitement around the sci-tech board has stoked caution. The first batch of mutual funds set up to invest in the board were oversubscribed by up to 10 times in April.2

We believe China has gleaned lessons from the past, and it has acted to prevent bubbles on the sci-tech board. The registration-based IPO system and more market-oriented IPO valuations could prompt investors to be more discerning. To encourage IPO sponsors to set reasonable valuations, regulators require them to co-invest in the deals and hold their stakes for some time. Direct access to the board would also be limited to institutional and select retail investors seen as more sophisticated.

What we’re watching

What would persuade us to invest? As fundamental investors in search of sustainable investment returns, we will be watching at least two key factors—the quality of companies listed and their valuations.

To be sure, much remains to be seen until the board starts trading. By late April, 90 companies from industries ranging from advanced equipment to biomedicine had cleared the initial checks needed to list.3 Most applicants were not high-profile market leaders, which is unsurprising as bigger names are more likely to be listed already. Broadly speaking, we expect regulators to be mindful of the overall quality of companies listed, especially in the near term as they work to cement market confidence in the board.

Meanwhile, short-term valuations on the sci-tech board could be choppy, even as certain features curb extreme froth. We could see share prices perk up on strong investor interest and trading volumes after the board debuts, before settling down at more reasonable levels over time.

As a whole, we think the sci-tech board is well-placed to help emerging companies grow into industry champions in the long run. But identifying companies with the right potential would require investors to have strong research skills. Especially for firms with short track records or early-stage innovation, financial analyses should be accompanied by hands-on research, including company visits and meetings with suppliers, regulators and other major stakeholders, to build a well-rounded view of their prospects. Shares of such companies could also be more volatile and less liquid, which would affect portfolio construction. Until we can identify good-quality companies that demonstrate enduring earnings power but appear mispriced by the market, we are likely to stay on the sidelines.

All aboard?

All said, we welcome the launch of the sci-tech board. We view it as a crucial step in China’s economic restructuring, especially in its race to become a leading innovator and pursue technological independence from the West. The board is likely to broaden companies’ access to private capital and deepen capital market reforms. It also has a significant part to play in upgrading China’s industries, by unlocking a source of financing for homegrown companies in high-tech or research-intensive fields.

Still, we see a need to distinguish the macro from the micro. In our search for sustainable investment returns, we will be paying close attention to the quality of companies listed and their valuations. We believe it will take nothing less than solid research and a sensitivity to valuations to uncover companies that demonstrate enduring earnings power but appear mispriced by the market.

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ENDNOTES

  1. WIPO (2018). World Intellectual Property Indicators 2018. Geneva: World Intellectual Property Organization; OECD (2019). Main Science and Technology Indicators, Volume 2018 Issue 2, OECD Publishing, Paris.

  2. Shen, S., Ruwitch, J. April 30, 2019. “New funds targeting China’s Nasdaq-style tech board in hot demand.” Reuters.

  3. April 23, 2019. “Q&A on First Round of Inquiries and Replies for Sci-Tech Innovation Board.” Shanghai Stock Exchange.

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments.

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