The illusion of never-ending growth at ChiNext, China's Nasdaq-like growth enterprises board, dissipated like morning fog as companies released 2010 annual and 2011 first quarter financial reports.
With almost every report, the ChiNext index slipped another notch. Altogether the index fell nearly 9.5 percent in April alone, bottoming at around 897 points at month's end.
Some 55 stocks have lost more than 30 percent of their value since the beginning of the year, and share prices for 37 percent of the listed companies have fallen below initial public offering levels.
Currently some 212 companies trade on ChiNext, which was launched in June 2010 as a bourse for high-tech start-ups. About six companies join the board every week.
Moreover, the average price-to-earnings ratio for ChiNext companies has slid significantly in recent months. It was just over 40 as of mid-May, about half the average P/E ratio in the second half last year.
A decline for the P/E ratio was not unexpected because the China Securities Regulatory Commission (CSRC), in hopes of skimming market froth, last year took steps to accelerate a ChiNext expansion by speeding up IPO approvals.
But some market watchers wonder whether the regulator's strategy went too far. Besides, many ask, is it wise to push company values downward on an exchange without a delisting mechanism?
Researchers at ChiNext's parent bourse, the Shenzhen Stock Exchange, have offered a positive explanation for the downturn: They say the growth board's companies are not growing as rapidly now that they are shifting from an early development-fast growth stage to a more mature, slower and stable side of the cycle.
They also point to a slowdown in some areas of the Chinese economy as a reason for weaker company financials.
Indeed, the board still has plenty of cheerleaders who say the go-go days are not over yet.
"ChiNext firms should play a role in emerging industries, and they have just entered their growth stages," said an investment banker. "They are not big, which allows them to grow more than 50 percent each year."
Figures gleaned from 2010 annual reports show ChiNext companies realized overall revenue growth of 31 percent last year. Small- and medium-sized enterprises listed on Shenzhen exchanges reported combined growth of 32 percent, while the Shenzhen main board companies boasted growth as high as 42 percent.
But every party eventually ends. And the latest figures suggest that a lot of the talk about sky-high growth potential for ChiNext companies may have been based on myth.
While ChiNext enjoyed solid growth last year, with the index gaining 25 percent between June and December, it has so far this year lagged far behind other mainland stock exchanges.
Chinese equities researcher Wind Info recently reported that 23 percent of 209 companies on ChiNext posted lower net profits for the first quarter compared with the same period last year. The quarterly reports also show a large number of listed companies saw year-on-year revenue decline.
Rules and Critics
Beyond the earnings reports, though, regulatory requirements have negatively affected recent stock performances on ChiNext, argued a brokerage executive in Shenzhen.
ChiNext applicants must meet several specific financial conditions that critics say clog the investment wheels. One rule says a company must post profits for the previous two years, accumulating net earnings of at least 10 million yuan. Alternatively, a company can list if it reports net earnings of at least 5 million yuan for the previous year on revenues of at least 50 million yuan, and two years of revenue growth of at least 30 percent.
"Some say a company can list "with net earnings of 10 million yuan," said a private equity expert familiar with ChiNext investments. "But in fact, CSRC would not even look if (a company's) net earnings are below 40 million yuan."
The investment banker said the lengthy regulatory process can prevent investors from supporting companies during periods of fastest growth. If a company is allowed to tap the growth board at an early development stage, he said, its growth would accelerate at a faster rate than if it's fueled with private or bank funding.
The banker also said it's short-sighted to assess ChiNext companies based on results from the year before a proposed listing.
He called for "a practical solution" that lets "companies disclose relevant information more thoroughly, while the external environment, including the market, media and regulators, show certain tolerance toward failures on ChiNext."
CSRC says its rules are designed to control fund-raising and prevent using ChiNext listings to exploit investment funds. Moreover, the Shenzhen exchange says it backs investors by requiring ChiNext companies to set aside newly obtained funds in dedicated accounts for six months, and then use the funds only for core operations – and certainly not for securities, derivatives, or venture capital investments.
Regulators also prohibit the use of proceeds for acquisitions. But this rule "in fact has made it almost impossible" for a company "to tap the capital market for financing of merger or acquisition activities," said an M&A expert.
Another turn-off for ChiNext investors is tied to the fact that, due to regulations, nearly 70 percent of proceeds raised through the stock market are currently idle and generating no returns.
A Shenzhen exchange report May 3 said only about 31.5 billion yuan of the 100 billion yuan set aside by companies since their ChiNext IPOs has been spent so far. The rest remained locked in deposit accounts.
With much of their money frozen, ChiNext companies reported an average 2010 return on equity of only 8.7 percent. That compared to a 14.4 percent ROE for companies listed on the Shanghai A-share market.
Yet another complaint is that ChiNext has yet to hammer out a delisting scheme for its companies.
"The absence of a delisting mechanism and the possibility of back-door listings have actually provided insurance for listed companies," said an "It does not matter how badly they perform. It's a twisted system."
But that could change soon. Ouyang Zehua, deputy director of CSRC's Listing Division, said in March that the agency has formed a panel to study delisting rules and draft a plan.
What eventually emerges "will be a whole solution, whereby both the main board and ChiNext are given due consideration," Ouyang said.
Nevertheless, a source close to CSRC said commission officials have yet to reach consensus on delisting rules.
A Huatai Securities analysis found that funds have been shying away from new issues on ChiNext since January. Subscriptions have fallen dramatically in line with falling share prices.
Yang Delong, a fund manager at China Southern Fund, told Caixin that the pace of new issues was too fast. He also urged stricter regulations that help ensure the quality of companies seeking growth board support.
Regulators, however, have generally encouraged more company participation on the board.
One commission staff member said a bubble "would exist for sure when there are only 100 or 200 companies" on ChiNext. "But it will go away if there are 600 or 1,000 companies.
"The listing rate for the ChiNext market will not slow going forward."
If that forecast holds true, P/E ratios for ChiNext companies will likely continue to fall while the fog generated during the bourse's fast-growth era slowly vanishes.