The Shanghai Stock Exchange Science and Technology Innovation Board (the "STAR Market") was founded in July 2019 as a board listed on the Shanghai Stock Exchange meant to promote the domestic development of research-driven, technologically advanced companies that have the potential to be the future driving force of China's economy.
In this article, we provide a recap of the "Piloting STAR Market and Experiment Registration System Implementation Directives" published in June 2019 by the China Securities Regulatory Commission. These directives were subsequently approved by the State Council (i.e. the chief administrative authority of China) and the Central Committee, meaning that the central government is fully onboard with and supportive of the implementation of the new directives. Moreover, we highlight the characteristics of standout companies and key sectors relevant to the Market, in addition to investor requirements to participate and the related risks associated with investing.
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What is the Purpose of the STAR Market?
The STAR Market serves a crucial purpose in promoting technological and economic advancement key to China's future growth and success. The Market was created to allow companies that align with the country's national strategy of technological competitiveness (as highlighted in Made in China 2025 and China Standards 2035) to obtain easier access to financing. This includes companies that specialize in new generation information technology, advanced equipment and materials (e.g. semi-conductor manufacturing), alternative energy, biopharmaceuticals, as well as other strategically important new industries.
The establishment of the STAR Market is part of China's overall strategy to foster "new economy" developments, including the integration of the internet, big data, cloud computing, and artificial intelligence, with the traditional manufacturing process, in order to develop and cultivate high-value production and consumption. For example, on the manufacturer side, companies can use the internet and AI to more effectively determine the amounts of each good they should produce in order to minimize the number of leftover products in their inventories. The use of sophisticated technology to analyze consumer trends and preferences can also allow companies to develop products that better meet consumer meets. On the consumer side, Chinese consumers will have a larger selection of targeted and innovative products to choose from, in line with their rising income levels and purchasing power as China attempts to transition from a low-value manufacturing economy to an advanced economy driven by the production and consumption of innovative and high-value products.
What Types of Companies List on the STAR Market?
Companies that are technologically innovative and/or have made breakthroughs in advanced technology are encouraged to list on the STAR Market. As of April 2020, the 100 companies listed on the Market back then released their annual financial reports for the first time. A thorough look at these reports shows that STAR-listed companies tend to have a significant focus on research and development (R&D) and usually possess market-leading technology.
STAR-Listed Companies Have a Significant Focus on R&D
On average, R&D spending makes up 11.3% of total revenues for companies listed on the Market
On average, 30% of employees working in STAR-listed companies are employed in R&D
STAR-Listed Companies Possess Market-Leading Technology
63% of companies listed on the Market are identified to possess technology that is market-leading domestically in China
21% of companies listed on the Market are identified to possess technology that is market-leading internationally
The Role of Chip Manufacturers
As part of the US-China trade war, the US implemented export controls whereby American and non-American companies that use American technology are required to apply for a license from the US government in order to export to Chinese companies placed on America's sanction list. These export controls cover chip manufacturing companies, including semi-conductor producers that manufacture key inputs used in the production of various electronic devices ranging from household appliances to consumer electronics such as laptops and mobile phones.
Advanced semi-conductors are considered as perhaps the most complex and sophisticated form of production input product with very few countries in the world possessing such technology. The trade war has thus prompted the Chinese government to focus more significantly on developing the domestic semi-conductors manufacturing industry. The Chinese government had initially set up a state fund worth approximately RMB100 billion to support the financing of semi-conductor research and production in 2014, but following the developments of the trade war in 2018, a second fund was set up in 2019 with double the funding amount to invest in many of the relevant STAR-listed companies.
Moreover, China's five-year plan for 2021 to 2025 emphasizes state support for the development of third-generation semiconductors (i.e. the newest and most advanced form of semi-conductors), including the education, research, financing and application of such products. The ultimate goal is for China to achieve self-reliance and independently produce a sufficient amount of high-tech semi-conductors so that US sanctions would be less effective.
The STAR Market includes tens of chip manufacturing companies, with two particularly noteworthy ones being:
1. Semiconductor Manufacturing International Corporation (SMIC)
SMIC is a partially state-owned chipmaker company headquartered in Shanghai that is also the largest chipmaker in China. The company has a dual listing in Hong Kong and is currently export-controlled by the US. On the day of SMIC's IPO on the STAR Market, the company's share price soared 200%, resulting in a 320% premium compared with the equivalent share listed on the Hong Kong Stock Exchange. A reason for this is investors' speculation of increased government support for chip manufacturers, an expectation of increased demand for semi-conductor companies, as well as the overall scarcity of high-quality tech companies listed in China.
2. Advanced Micro-Fabrication Equipment China (AMEC)
AMEC is a company that develops chip-making equipment. It is the Chinese leader in the micro-fabrication sector, which is currently dominated and led by Lam Research and Applied Materials, two American companies. AMEC's current products are not world-leading, but the company will likely benefit from state support as part of the government's initiatives to promote the domestic development of chip manufacturing machinery.
Growth of the STAR Market
The STAR Market is the fastest growing board in China in terms of the number of IPOs. The Market initially started out with 27 companies in July 2019 and has grown to 200 companies in December 2020.
Investor Requirements to Invest in the STAR Market
Retail investors must have at least two years of stock trading experience with a portfolio of investment securities worth at least RMB500,000 to qualify to invest in the STAR Market. These requirements are in place to make sure that only investors with a sufficient level of financial experience and sophistication can participate, since the STAR Market comprises of companies that can be much more risky with potentially very volatile returns. However, retail investors who don't quality can still invest indirectly through funds that invest in the STAR Market.
Risks Associated with Investing in the STAR Market
There are several risks involved in investing in the STAR Market, which we highlight here:
Unpredictable Cash Flows and Uncertain Future Profitability
Most companies listed on the Market are currently unprofitable (as is the case with most young tech companies). Their cash flows and future profitability can be very unpredictable.
Adverse Selection
Since investors tend to view STAR-listed companies as market-leading tech firms with very promising growth prospects that are also likely to enjoy government support, the stocks of these companies tend to trade at a premium. Certain companies may try to exploit the high valuation premium associated with being listed on the STAR Market by trying to appear as research-driven, high-growth tech firms without actually possessing the supporting fundamentals. This issue highlights the double-edged sword nature of the registration-based system used in the STAR Market where young, promising tech firms could find it easier to list in China due to the less stringent requirements (as opposed to the traditional approval-based system used in China's other boards except ChiNext), while at the same time weaker companies might try to exploit this leniency to gain additional funding and high valuations.
Difficulties in Conducting Due Diligence
It is far from easy to conduct the appropriate due diligence for young tech firms such as those listed on the Market. Most ordinary investors would not be able to readily verify the level of technological prowess that STAR companies claim to possess.
For example, the stock price for Junshi Bio, a biotechnology company listed on the Market in July 2020, went up by 200% the day of its IPO. Investors were very optimistic about the company's growth prospects given the number of high-profile academics and industry experts associated with the firm. However, a subsequent report later revealed that the company had questionable research capabilities with no particular competitive advantage, in addition to collusive agreements between the founders of the company and the high-profile experts associated with the firm. This resulted in Junshi Bio's share price falling by over 60%, from RMB220 per share at its peak during the first week of trading to only RMB70 per share after the report was released.
Policy Risks
Companies listed on the Market primarily focus on just a few high-tech industries that can be very heavily influenced by policy changes. For example, in response to the US-China trade war, the Chinese government further increased investment in the semi-conductor industry which drove investor demand for chip manufacturing companies listed on the Market.
Market Volatility Driven by Speculation
The STAR Market is driven, at least to some extent, by speculation. Since STAR companies represent sectors that play a strategic role in China's 2035 Plan, investors generally anticipate some degree of government support and are willing to pay a premium to invest in these companies. For example, the Kechuang 50 index, which tracks 50 companies listed on the STAR Market, started trading at 1,000 at the start of 2020 and peaked at 1,726 in July before dropping down again.
Updates (note: this section will be continually updated)
UPDATE 03/02/2021: 12 STAR-Listed A-Shares Eligible for Institutional Investors on Stock Connect Starting Feb 1st
As of February 1st, 2021, A-shares listed on the STAR Board that are also constituents of the Shanghai Stock Exchange's SSE180 Index and SSE 380 Index, as well as those with an H-share counterpart listed on the Hong Kong Stock Exchange, will be eligible for trading via the Stock Connect platform. In total, 12 A-shares will be added, Advanced Micro-Fabrication Equipment China (AMEC) discussed above. Only institutional investors will be eligible to invest in these A-shares.
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