One of the benefits of having functioning brain cells during such an important period in China’s history is the educational entertainment of all the lofty theorizing. Everyone likes to talk about the higher meaning of what seems like every transaction southeast of the Great Wall. Last week was another example, as reports about Thursday’s initial public offering (IPO) of China’s Construction Bank (CCB) were scrutinized with so much fervor that you’d think China’s stock prices held the secret to next year’s Super Bowl winner or tomorrow’s PowerBall ticket.

Granted, CCB is no small shop. Boasting $381 billion of assets and employment of 410,000, it stands proudly as China’s third largest bank, and the world’s 12th largest. In addition to its own ego, the first sale of its shares to the public was supposed to support part of a grander plan of China’s government to gradually rid itself of inefficiencies and corruption of state-controlled banks. No doubt the event earned some print.

But the way the media interpreted trades of the new stock the day after it was issued to the public was a little over the top. CCB’s trades happened to cling tightly to the price of the initial offering, which meant that the parties involved were disappointed. The media jumped all over the event and reports like that by the Wall Street Journal interpreted the “failure” as a sign of a “meek” performance of Chinese IPOs; an announcement of investor “skittishness”; and bad news for future Asian equity offerings. To them, CCB was a Magic 8 ball, and China’s entire Outlook was Not So Good.

See, an IPO is the very first sale of a stock in a company to the public. Because it’s the first, potential buyers don’t have all the information that they might otherwise have on seasoned public companies, which are required by law to be much more transparent. To compensate for this lack of information, the company (usually through an investment bank) goes on road shows to pitch its stock to large institutional investors. Based on the general trend in IPO results, and on the rosy sales pitch often offered by the investment bank, these investors sign up for the risky deal expecting a rather significant and immediate jump from the price at which they commit to buy the stock. This jump averages about 10% in the United States – not bad for 24 hours.

So the fact that the stock didn’t skyrocket after the IPO left those who had agreed to get in on the deal a little shier than all of those dotcom-esque investors who flooded the papers with their 100% overnight returns a few years ago. But does the lack of profit really indicate a meek market and a terrible future for Asian investments?

What if CCB just happened to price the IPO at a high price?

You see, there are two sides to the equation. From the perspective of the discontented profit-seekers, either the after-IPO share price didn’t jump high enough or the IPO price wasn’t set low enough. The media has been focusing on the former as the driver, calling the disconnect between investors’ hopes and the post-IPO share price a negative sign for the markets. But whereas the post-IPO share price is set by market forces, the initial offering price was set by the investment bank and CCB. This is not an exact science, and leaves plenty of room for error.

Because one can’t see market forces of supply and demand of the stock in action yet, the IPO price is set based on a bunch of analyses. These analyses require quite a bit of interpretation and take into consideration things like the historical and projected financial results of the company, valuations for comparable companies, assessments of market conditions, the marketability of different price ranges, and the percentage of the company being sold. In other words, there exists no plug-and-chug formula that guarantees a perfectly accurate price.

What if CCB was overly optimistic in its estimates, or wrongly assessed market conditions? After all, on October 13th the company announced a range for the final price ($1.90-$2.40) and then ended up choosing a price at the high end of that range ($2.35). So it was being slightly aggressive even by its own uncertain calculations. In addition, note that this range had been set just a mere 2 weeks before the issuance, so chances that markets had time to readjust so severely are slim.

Another explanation may have to do with CCB’s need for cash. One of the goals of an IPO is to raise as much cash for the issuer as possible, and CCB has certainly demonstrated need. It received an enormous injection of cash from the government in December 2003 of $22.5 billion. What if stricter capital adequacy requirements and the need for liquidity to shrug off competitiveness concerns led CCB to prioritize this goal over ensuring a buoyant secondary market?

Even if these are not the primary reasons for the lack of blockbuster performance of the stock, the point is that they should at least be considered. The media’s tendency to insist that isolated events are market forecasts prevent the whole story from being told.

In their defense, however, the media did get one thing right: the lack of underpricing will make everybody’s jobs harder next time.

Now that initial investors are upset with the lack of profit they made on the deal, it will be harder for the company to get cash again soon. Not only will have to low-ball the price for their next IPO, they’ll probably need to pay the investment bankers more money to do a harder selling job. This is precisely why most IPOs are underpriced. The better the IPO works out for the investors the first time, the more willing investors are to pony up the dough and the easier it will be to make the sale the next time. Now that CCB has disappointed the big boys, they’ll have to do some groveling next time they want to sell new shares.

Posted by Michelle Smith on November 1, 2005 07:24 AM