On March 10, 2022, the SEC identified the first five US-listed Chinese ADRs that will be subject to forced delisting with a three-year countdown upon finalisation.
As required by the Holding Foreign Companies Accountable Act (HFCAA) that was passed in 2020, the SEC has the responsibility to delist companies from US exchanges if the Public Company Accounting Oversight Board (PCAOB) is unable to review companies’ audits for three years consecutively.
The first batch of ADRs identified as failing to comply with the HFCAA are Yum China, BeiGene, Zai Lab, ACM Research and HUTCHMED, as they recently filed annual reports with SEC. Four of these companies already have been listed in Hong Kong and China although liquidity remains higher in the US markets.
In a report dated March 14, JP Morgan says other Chinese ADRs that do not satisfy the rules could be included in the future as well following the aforementioned treatment. Companies on the list can apply to appeal the decision within 15 days of the announcement if they believe they have been incorrectly identified. The ADR de-listing is an important reason for the current sell-off in Chinese tech stocks.
Additionally, JP Morgan believes that the ADR de-listing is the “last straw that shook investor confidence in the sector.”
As JP Morgan sees it, the ADR delisting risk translates into liquidity risk, as opposed to sovereign risk because 1) most of the large China Internet names have already done their Hong Kong IPO; 2) the Hong Kong line and ADR are fully fungible; and 3) liquidity in Hong Kong is much lower than that in the US.
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Geopolitical risk
On the geopolitical risk front, the ADR delisting risk is a reflection of China’s reluctance to allow audited book inspection of its listed companies from an external jurisdiction.
“We believe the SEC announcement has triggered investors to reassess China’s geopolitical risks, which has led to significant fund outflows from the Internet sector as global investors rebalance their global capital allocation,” JP Morgan says. '
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Over and above this risk, institutional investors are already nervous over rising interest rates, inflation and now the Russo-Ukraine War.
Although the Hong Kong-listed Internet stocks are not subject to the de-listing risk, geopolitical and economic risks have triggered a sell-off.
“As the Russia-Ukraine conflict continues, we believe global investors are increasingly nervous about geopolitical risks to China as more and more countries and corporates impose sanctions on Russia. Russia’s equity market fell 33% (MOEX index) on February 24, 2022 before the suspension of trading on February 25, 2022,” JP Morgan observes.
“Despite the fact that many coverage stocks have fallen below their historical trough valuations, we do not think there will be valuation support to the sector in the near term.
"As the near-term goal of investors is risk management, rather than stock returns, we believe that valuation frameworks based on fundamental analysis will not be relevant to trading activities until the outflow stabilises,” the report adds, and suggests investors should wait 6-12 months before deciding whether to invest.
Photo: Bloomberg
