The lack of coordination and coherent policy on China has sent mixed signals and confusion to American investors investing in Chinese companies listed on the NYSE. Collectively, this represents over $1 trillion worth of shares trading in the US. In an unprecedented move, on Dec 31 the NYSE announced it would delist several Chinese companies. Over the next 24 hours, the exchange reversed this decision — and then, under pressure from the Treasury Department, again said it would delist the stocks.
Qilai Shen/Bloomberg News
Under the Biden administration, what does this mean for financial advisors as well as investors? More importantly, should Beijing retaliate, what are the critical implications this could have on U.S. and global markets?
This about-face in policy change is part of a broader set of disputes between the U.S. and Chinese regulators. For years, American regulators have complained that firms whose parent companies are based in China but have subsidiaries located in the U.S. are not held to the same audit standards as U.S. firms. In response, President Trump, in August of 2020, issued a set of recommendations intended to address the inability of the US audit regulator — the Public Company Accounting Oversight Board (PCAOB) — to inspect accounting firms based in China whose audit involves clients listed on U.S. stock exchanges. Accounting firms that audit companies that raise capital in U.S. markets are required to be registered with the PCAOB and adhere to stringent U.S. audit standards under the Sarbanes-Oxley Act of 2002. However, the PCAOB and Chinese authorities have been unable to agree to a joint inspection program despite more than 13 years of intermittent negotiations.
On Jan. 13, the Trump administration banned U.S. investors from investing in 39 Chinese companies with alleged ties to China’s military. At the core of President Trump’s executive order is a significant case involving a Chinese company defrauding US investors. In April of 2020, Luckin Coffee, which competes against Starbucks, admitted to fabricating $309 million in sales revenue. As a result, Americans who invested in Luckin saw the share price plunge by 75% overnight, and the firm was required to pay a $180 million penalty to the SEC.
Implications for advisors and investors
For advisors, RIAs, and family offices seeking to advise clients on what to do with investments in Chinese companies forced to delist, begin by first reassuring them that this is not an apocalyptic omen. Clients need to understand that delisting doesn’t mean they can’t sell their stock; they just can’t trade on the exchange. There are several second-tier levels in the market ecosystem, where investors holding delisted stocks can still buy and sell shares of “less qualified” companies in what is known as “over-the-counter” markets — such as the OTC Bulletin Board, and even lower, the “pink sheets”. For advisors, it is critical to understand the financial situation of each client and how much exposure these investments comprise of their overall investment and current liquidity needs. Clients who have more pressing liquidity needs will need to develop an exit strategy faster than accredited investors who are more bullish on growth in China and who can wait longer to sell their stock.
Investors could also wait to see if the Biden administration might change course on the delisting ruling. U.S. investors who have invested in soon-to-be delisted Chinese companies have until November 2021 to trade their shares on the NYSE. China has so far taken a wait-and-see attitude toward the ruling and any Biden changes. It’s unlikely that the Biden administration will rescind the order, though. One of the by-products of the Trump administration’s adversarial tone on China policy is that it resulted in both Republicans and Democrats on Capitol Hill taking a harder stance on China, particularly as it relates to American consumer and corporate interests.
What has been fascinating is that despite a trade war and executive orders calling for Chinese companies to be delisted, Chinese firms have continued to list or “cross list” on U.S. stock exchanges. Cross-listing is the listing of a firm’s common shares on a different exchange than its original stock exchange. Chinese and other foreign companies choose to do this because they can get higher valuations when they cross-list in New York, compared to companies that do not cross-list. As of Oct. 2, 2020, there are 217 Chinese companies listed on U.S. exchanges with a total market capitalization of $2.2 trillion.
The China growth story: Risk vs. reward
For financial advisors and investors looking for growth and yield during a global pandemic, China may provide an attractive market. China surpassed the U.S. as the world’s top destination for new foreign direct investment (FDI) in 2020. In early 2020, largely due to Chinese officials’ actions and mismanagement of information involving COVID-19, FDI in China declined by 42% to $859 billion, a 30% drop from even the lows of the 2009 financial crisis. However, Chinese officials immediately took measures to control the spread of the pandemic and reassure investors.
As China’s recovery gained traction, while the pandemic continued to spread globally, foreign investors returned to investing in China. However, it is critical that financial advisors and investors alike do their due diligence when investing in Chinese companies. In the case of Luckin Coffee, the company opened 500 stores in less than eight months faster than Starbucks, doubled its valuation to $12 billion in eight months, and then went public in only two years. China’s ability to control COVID-19 within its borders has enabled it to reopen to investors, but that doesn’t mean that it is a panacea for all investments. Financial advisors must develop a more nuanced understanding of the business, legal, and geopolitical risks and explain these issues alongside the impressive growth figures. More importantly, they also need to incorporate a diversified portfolio as well as a hedge to downside risk to more effectively quantify the overall investment opportunity.