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Hong Kong's Enigma crash reinforces small-cap fear
June 30, 2017 / 6:01 AM / 3 months ago

Hong Kong's Enigma crash reinforces small-cap fear

Activist shareholder David Webb poses in Hong Kong, China June 28, 2017. REUTERS/Bobby Yip

HONG KONG (Reuters) - Trouble in Hong Kong’s “Enigma Network” calls into question official efforts to encourage more small-cap listings. Investors were already increasingly wary about smaller stocks. Restoring trust will take stronger rules and better enforcement.

More than a month ago, activist investor David Webb published an article titled “The Enigma Network: 50 stocks not to own”. The market initially shrugged off his warning about the web of cross-holdings among some 50 stocks. Then investors abruptly dumped shares in of some of these firms on Tuesday for no clear reason.

Graphic: Small cap indexes have underperformed Hong Kong's benchmark Hang Seng index: reut.rs/2tw6EoR

Some were already the subjects of warnings by the Securities and Futures Commission, the local regulator, that shareholdings had become highly concentrated. Others had absurdly high valuations. Civil engineering firm Luen Wong Group, for example, was trading at a price-to-earnings ratio of over 800 when it received investment from China Environmental Energy Investment. Luen Wong shares dropped 90 percent during the crash.

This builds on an existing trend. Investors have grown weary of small cap shares in Hong Kong and China. The index of small caps listed on Hong Kong’s main board is down 34 percent from a peak in 2015. The mainland Chinext growth board is down 45 percent over the same period. Hong Kong’s junior Growth Enterprise Market (GEM) is down a whopping 65 percent. 

This is partly about reversing a rally that got out of hand. The declines also reflect wariness about the quality of these companies and their governance. GEM, extraordinarily, brands itself as a “Buyers Beware Market for Informed Investors”.

The Hong Kong Stock Exchange wants to attract more hot startups to its staid bourse, currently dominated by old-economy stalwarts such as banks and property developers. The exchange is mulling a “New Board” that would focus on attracting such firms.

But activists like Webb worry current regulations are inadequate, as is enforcement. The list of worries include obfuscated cross-shareholdings, weak disclosure, and the ease with which companies, once listed, can sell off assets and switch their focus without consent from minority shareholders.

He has a point. Right now, urging “caveat emptor” will not cut it. A flood of new small cap debutants would only make the problem worse. Hong Kong ought to clean house first.

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