MSCI Boils the Interchina Bubble
16 May 2002
updated 21-Jun-02
Remember our story Interchina Bubble, back on 23-Oct-01? We explained then how the stock of Interchina Holdings Ltd (Interchina, 0202) had been cornered and ramped, and was trading at around 16.4x net assets, and this was primarily a property company.
Well since that article, the stock fell from $1.62 to touch a low of $0.63 on 7-Jan-02, and has since rebounded to $1.24, where it was suspended on 14-May-02, after rising from $0.83 in just two trading days.
Recent events
Before the index problem, let's have an update on what this company has been doing since our last coverage.
Scrapped convertible note
Readers may recall that Interchina had announced a placing of $100m convertible notes with Guotai Junan Securities (Hong Kong) Ltd on 14-Sep-01, the day that the stock hit its record daily high of $1.67. The notes were to be convertible at $2 per share or higher. That was also the day that the company put out a concentration warning after an SFC investigation had concluded that the controlling shareholder together with 15 "major public shareholders" held 90.2% of the company and 13 of them had accounted for 40% of the volume between 31-Jul-01 and 6-Sep-01. That is the SFC's way of telling you that the stock has been cornered.
On 14-Nov-01, the placing of convertible notes was scrapped, due to "unfavourable market sentiment". In the two months since the placing was announced, the stock was down 24.0% to $1.27.
Increased stake in brokerage
On 23-Nov-01 Interchina agreed amongst other things to increase its stake in Interchina Securities Ltd (ICS) from 70% to 85% by capitalising $50m of existing loans, partly to provide capital to expand the margin financing business.
Interim results
On 19-Dec-01 Interchina announced its results for the 6 months ended 30-Sep-01, with a net profit of HK$139.9m on turnover of just $35.5m. However, the profit was due to a one-time gain of $149.2m on the disposal of a property subsidiary, which was completed 1 day before the end of the period. This property, Beijing Jingshan Interchina Commercial Building, was a legacy from the days when Interchina was known as Burlingame, and it had previously been held at a very low book cost, resulting in the gain on disposal.
Excluding the property disposal, the company made an interim net loss of $9.3m. The balance sheet in the interim report shows net tangible assets of $555.9m or $0.127 per share.
New INED - Allen Lee
On 1-Mar-02, Mr Allen Lee Peng Fei (Mr Lee) was appointed as an independent non-executive director. Mr Lee is a deputy of the National People's Congress and a former member of HK's Executive Council (1985-92) and Legislative Council (1978-97).
His other positions include wet-market operator Wang On Group Ltd, of which he has been an independent non-executive director since Nov-93. The company listed on 28-Feb-95 with a first-day adjusted closing price of $0.516, and now trades at $0.021, down 95.9%. After the customary first year of post-IPO profits up to 31-Mar-96, it plunged into loss, and has only had one profitable year since then, in 2000.
Mr Lee has also been an independent non-executive director of toy designer Playmates Interactive Entertainment Ltd, since Nov-93. The company was listed on 6-Jan-94 with an adjusted first-day closing price of $2.403. Today it trades at $0.255, down 89.4%.
For many years (since at least 1996), Mr Lee was Independent Non-executive Vice Chairman of retailer Tse Sui Luen Jewellery (International) Ltd, resigning on 20-Aug-99 when the share price was $0.225, having fallen 93.5% from an adjusted high of $3.463 on 1-Sep-97.
Mr Lee was appointed as an independent non-executive director of Karrie International Holdings Limited on 30-Oct-96, prior to its IPO which occurred on 16-Dec-96, when the stock closed at $1.02. The stock then was quickly ramped by parties unknown, reaching $3.35 on 13-Mar-97. Mr Lee resigned on 22-Jan-98, when the stock was $0.14, down 95.8% on its high and 86.3% on its first-day close.
Now to be fair to Mr Lee, he has had a vast number of directorships, and not all of those companies have lost money for investors. He is an independent director of Giordano International Ltd, and Kingboard Chemical Holdings Ltd, for example. But overall, we find the track record unimpressive.
More new Directors
On 13-Mar-02, Interchina announced that a string of appointments of "reputable individuals" (what does that imply?) had been made in the previous two weeks.
Mr Herbert Hui Ho Ming (Mr Hui) was appointed Deputy Chairman on 8-Mar-02. He was formerly Head of the Listing Division of the Stock Exchange, and since then has shown rather an affinity for bubbles (or perhaps, the other way around). He became Managing Director of red-chip Guangdong Investment Ltd on 1-May-97, when the stock closed at $7.40. He arrived just in time to see the red-chip bubble burst, and ended up working on restructuring the company. He resigned on 15-Jan-00 when the stock price was $1.23, down 83.3%.
Mr Hui then became Managing Director of GEM tech bubble stock Sunevision Holdings Ltd on 29-Jan-00, and the company was listed on 17-Mar-00 when it closed at $15.10. He resigned on 14-Nov-00, when the stock was $3.75, down 75.2%. Today it trades at $1.78.
Mr Hubert Chan Wing Yuen was appointed as an executive director of Interchina on 8-Mar-02. He spent 10 years at the Stock Exchange, eventually become Director of the Mainland Affairs Department of the Listing Division under Mr Hui. He joined Guangdong Investment Ltd as a director and Deputy General Manager on 23-Aug-97, three months after Mr Hui, and left on 1-Feb-00, two weeks after Mr Hui.
Mr Michael Wu Wai Chung (Mr Wu), was appointed as an independent non-executive director of Interchina on 11-Mar-02. He was Deputy Chairman of the Securities and Futures Commission (SFC) until 31-Dec-97 and is a full-time adviser to the China Securities Regulatory Commission (CSRC). At the SFC, he was executive director responsible for the Intermediaries Division (which includes brokers).
The final appointment was Mr Jack Zhang Jiyei, as an executive director from 8-Mar-02. Nothing is known about him.
Our key point in respect of all these appointments of "reputable individuals" as Interchina put it, is that reputable individuals do not imply any guarantee of financial or market performance.
Loan to Changsha City Government
On 21-Mar-02, Interchina announced that it had agreed to "participate and invest" in the Urban Development Scheme of Changsha New Sports City in Hunan Province, PRC. In actual fact, this deal was a loan of up to RMB480m (HK$453m) to a local government-owned construction company, secured on property, and the commitment amounts to 81.5% of the unaudited net tangible assets at 30-Sep-01. Surely, such a major disposal of the company's money should be treated as a Major Transaction, requiring a circular, detailed information, and shareholders' approval. But the SEHK responded to our complaint as follows:
"The co-operation agreement as disclosed in the announcement is not a notifiable transaction under Chapter 14 of the Listing Rules as it does not involve any acquisition of assets."
We believe that loans by any listed company (except for normal loans by licensed banks) should be subject to the same classification rules as any other notifiable transaction, as they represent a disposition of shareholders' funds.
Ironically, if Interchina had been purchasing bonds which were secured against the same property, then that might have been treated as a Major Acquisition of assets (the bonds) rather than a loan, even though the end result, namely a loan against property, is the same.
Convertible bond amended
On 23-Apr-02, Interchina announced that it had amended the conversion terms of its outstanding HK$200m convertible note, the terms of which were originally announced on 3-Aug-01. It was issued on 23-Aug-01 to Capital Champion Ltd (Subscriber), a BVI company, the owner of which has never been formally disclosed. The Subscriber nominated Mr Yan Liyan (Mr Yan) as an executive director of Interchina, and he was appointed upon the issuance of the note. He had a deemed interest in the note as disclosed under the Securities (Disclosure of Interests) Ordinance, but it was not clear whether or not he was the owner of the Subscriber.
Originally, the notes were convertible in the 12th, 24th, 30th and 36th months after issue, 25% each time, with carry-forward of unused conversion rights. They were convertible at the higher of (i) $1 per share and (ii) the 10-day average price prior to conversion. Under the amended terms, Interchina and the Subscriber agreed to convert the whole note by 30-Apr-02. As the shares were trading below $1 at that point, this resulted in the issue of 200m new shares at $1 each.
Mr Yan resigned as a director of Interchina on 8-Mar-02. Consequently, his share dealings are no longer discloseable. The conversion has the effect of increasing net tangible assets (NTA) (as of 30-Sep-01) to $755.9m, there are 4,595m shares in issue, and net tangible assets per share are $0.165 per share.
MSCI's Index Mistake
As a property stock, Interchina should trade at a discount to NTA, but at $1.24 (as suspended on 14-May-02), it was trading at 7.5x NTA of $0.165. The market cap of HK$5.70bn (US$730m) puts it in the top 70 HK-listed stocks!
Now we come to the real meat in the sandwich. Fund managers in Asia often "benchmark" their portfolios, that is, they compare their performance to, a stock market index. A popular series of indexes is the MSCI, produced by Morgan Stanley Capital International Inc.
On 7-May-02, MSCI announced that Interchina was to be admitted to the MSCI Small Cap Index and its components, including the MSCI Hong Kong Small Cap Index and the MSCI EAFE Small Cap Index (EAFE stands for Europe, Australasia and Far East). The announcement is here and the constituent changes are here.
According to the MSCI Methodology Book, which describes how the compiler selects companies for the index, eligible small caps have a market capitalization of US$200-1,500m, and the guiding principles for inclusion in the index include "investability". They look at the "traded value ratio" (a measure of liquidity, where constituents must be amongst the top 80% of the country's small cap universe) and the "estimated free float" which should be a minimum of US$100m.
It seems that MSCI was oblivious to the previous concentration warning or our previous article regarding the free float and trading of Interchina's shares. As a result, they have now created demand for the stock by anyone who feels compelled to track the MSCI small-cap index. Fund managers would do well to tilt their portfolios away from Interchina which should provide out-performance of the MSCI index as and when the Interchina bubble bursts.
Second bubble
Mr Zhang Yang, the Chairman and controlling shareholder of Interchina, also controls another listed company, Guo Xin Group Ltd (1215), which is a smaller company but in an equally spectacular bubble. We'll be writing more about that shortly.
Update, 21-Jun-02
The day after we published this article, MSCI announced that:
"based on additional analysis of publicly available information, MSCI is revising the free float estimate for [Interchina]. As the free float of this company is now estimated to be below 15%, Interchina is not eligible for inclusion in the MSCI Small Cap Index Series."
So far, Interchina has not bothered to announce the reversal, despite having announced the inclusion in the first place.
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