Date: October 26, 2009
by Roger Tan, SIAS Research
A few Singapore listed Chinese companies – also known as S-chips – have recently announced that they have been seeking dual listing in USA through the American Depository Receipt (ADR) system. Share prices of these companies soared when news of their dual listing hit the market.
However, some market watchers are wary. I recently came across an investment note that said investors should be warned that ADRs may not lift valuation especially for small companies such as China Taisan and Sinotel. It also said that ADR would only add burden to their financials and cited Creative Technology’s delisting from the US market as an example.
The comments on the note are not totally correct. Dual listing does add cost but it can also add value and this is especially so with small companies. Let me explain:
Agency Cost: When People Don’t Trust the Company
Why is it so difficult to trust a company? The answer is simple: because the firm is managed by people who do not have full ownership of the firm and therefore there is a chance that their (self) interest will not be aligned to that of the investors.
The result of this apprehension is that investors would lower the share price they are willing to pay causing a discrepancy between the price and value of the firm. This discrepancy is known as residual agency cost.
Signaling: When Talk is Cheap, Do Something More Credible
Residual agency cost is exacerbated by the fact that investors often do not have full access to information on the firm and the management to determine the degree of “interest alignment”. As such, unless management is able to effectively communicate their intention to investors, investors will assume the worst possible scenario and apply the highest possible discount when pricing the firm.
Though management can proclaim that their interest is aligned to shareholders, such claims will not have any information value simply because “talk is cheap”. To send a clear signal to investors that their interest is aligned to shareholders, management must undertake some form of activity that will prove their claim. To ensure that the activity is credible, it should not be easy for others to imitate. Such an activity is known as “signaling”.
One example of a positive signal is the issuing of special dividends and the calling of rights issue at the same time. One corporate governance issue in many companies is the hording of funds by not declaring dividends to investors. Management usually has many excuses not to pay dividends but often these excess funds are also not used for further expansion (for working capital needs is nothing more than an excuse). By issuing excess funds back to investors and at the same time calling on a rights issue to fund future expansion plan, management is allowing investors to make educated decisions on whether to support the firm – thereby garnering for the vote of confidence.
Such an activity is not easy or cheap for any weak firms to undertake. Not only will the company incur cost to on raising the rights, they also face the possibility of not getting the funds back. This is therefore a strong signal of good corporate governance for any company who undertakes it willingly.
When to Stop Yelling?
How much signaling activities should a company undertake? Like any other decisions, they should stop undertaking additional signaling activities when an additional dollar of cost undertaken yields less than an additional dollar of savings from lower residual agency cost. In other words, a firm cannot completely remove the apprehension discount in their stock prices. It can only minimize it through spending some resources on signaling activities.
Back to Dual Listing.
With the above in mind, we can now discuss the issues on dual listing. I believe there are a few separate questions in the investment note mentioned at the beginning of this article. Let me attempt to identify and answer each one accordingly:
| 1. Does Dual Listing Add Value to the company? | |
| Dual listing is really a signaling activity undertaken by the firm as discussed above. Whether such an activity will add value to the firm depends on the level of residual agency cost the company is currently facing and the amount of reduction it can achieve by undertaking this activity. Dual listing through ADR is definitely not easy and definitely not cheap. Not only must the company find a willing sponsor to underwrite the ADR, it must also ensure that the business will appeal to the US investors. For companies who seek the ADR levels II and III listing, they must also undertake the pain and cost of preparing a separate financial statement to satisfy the US accounting standard. ADR is therefore a credible signaling activity to undertake. However, this signaling activity will only add value if there is a good level of residual agency cost that can be reduced. This is where I have to disagree with the statement that the ADR “will not add value especially for small companies such as Sinotel and China Taisan”. | |
| 2. Does Dual Listing Add Value to Small Companies? | |
| Small companies and especially S-chips have gone through a challenging period since 4Q08. Investors generally avoided these counters due to fear of poor corporate governance. Many S-chips had been priced well below their potential value. For some time, well managed S-chips were not been able differentiate themselves from the rest until the idea of a dual listing through ADR came along. We have seen the positive effects of using ADR as a signal by small firms. The claim that ADR does not add value to small companies is therefore flawed; ADR can be a value adding signaling strategy especially for small firms with a high level of residual agency cost. | |
| 3. Does Creative Technology’s Delisting Proof that Dual Listing Adds only to Cost? | |
| To enhance the effectiveness of the dual listing as a signaling strategy, a company will need to list in a market that has more stringent listing requirements than the one that it is already listed on. This is what the S-chips have been doing – listing in the US. Creative Technology on the other hand did the reverse. It was first listed on Nasdaq in 1992 and subsequently on SGX in 1994. It subsequently delisted itself from Nasdaq in 2007 due to the high administrative cost and low trade volume in the US. Creative Technology had very small level of residual agency cost and therefore it made sense not to undertake such cost in their operation. Using Creative Technology to highlight the disadvantage of dual listing is therefore not appropriate and can be misleading. |
Experience Can Be a Hindrance
The world of finance and investments has been well explored by many renowned academics over the years. Many phenomenons can be easily explained if one simply put in some effort to understand research work that is already in the market.
Market participants should not rely on their own observations and heuristics as a starting point to decipher a phenomenon. Doing that would often lead them to erroneous conclusions. This has been proven by many behavioral economics and finance studies. However, I believe that experience can be used to refine deciphering process.
What to Ask on the ADR?
Let me end this article by focusing our attention on what to ask on the ADR listing. There are three levels of ADR listing in the US and investors should check which level these companies are listing on – the higher the level, the more stringent the listing requirement.
Investors should also know the background of the sponsors as a gauge to the level of due diligence conducted on the firm.
Finally, investors should also check the level of institutional interest after the ADR listing. Institutions often have to conduct stringent due diligence check on a company before taking an equity stake. Checking on such information will provide further clues to investors over the value of the firm.
DISCLAIMER
This research report is based on information, which we believe to be reliable. Any opinions expressed reflect our judgment at report date and are subject to change without notice.
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