Seven requests for legal rescue of the market - using a reasonable progress view to solidify the stock market foundation

by wenhai4638 on 2012-02-13 14:35:56

In fact, a stock is a linear combination of a set of vector positions plus a bias term. If the error term of a company is positive, we believe that the company should expand externally; otherwise, it should become a merger target. It's not difficult to create a mechanism that incentivizes excellent companies to acquire other advantageous enterprises' assets through share-for-share mergers and acquisitions. The difficulty lies in the fact that every place has its own interests, which is a deeper level issue and also an urgent problem that the Shanghai and Shenzhen stock markets need to address.

I have just proofread and published the second edition of the textbook on "Financial Engineering," highlighting new insights about stock pricing. The past view was that stocks are the discounted value of future expected per-share cash flows. I think this is completely wrong. Treating stocks as fixed-income instruments for pricing (fixed-income instruments actually cannot be priced this way) has the flaw of being unable to determine the discount rate. I believe that a stock is actually a linear combination of a set of vector positions plus a bias term.

These vector positions can all be hedged. Take a simple example: a gold mining company's stock can be seen as holding a certain amount of gold reserves in the form of put options. The company has the right to sell a certain amount of gold on the market each year at the production cost as the exercise price, and the number of years until the reserves are depleted represents the quantity of one-year put options held by investors that continuously expire. People can completely hedge these put options in the capital market. For instance, if you buy one share of the company's stock and simultaneously sell a series of call options, you create a hedge portfolio that ultimately generates cumulative positive returns. The company's bias term being positive indicates good corporate governance, continuous improvement in discovering new deposits, decreasing mining costs, and improving refining levels. These are all the company's superior genes. If a company’s error term is positive, we believe that the company should expand externally; otherwise, it should become a takeover target.

Unfortunately, our current capital market does not operate according to such rules. The issuance review committee will not examine whether a company's error term is positive. They verify the company's refinancing needs based on financial indicators and predicted profits. This may halt the refinancing needs of some companies that actually possess superior genes.

There are many steel-related listed companies in the Shanghai and Shenzhen stock markets, nearly every province has a steel company, and there are constantly new expansion projects regardless of whether the stock market rises or falls. Their expansion plans seem always to gain approval from the management layer. These companies with negative error terms may release extremely beautiful financial reports during prosperous times and, with the help of sponsors, prepare very persuasive refinancing applications. However, such refinancing only dilutes their superior genes. Now is the time for us to clean up such A-share companies with superior genes. The capacity after these companies' expansions appears to increase the expected earnings per share but actually buries greater risks. The result is that during the peak of industry prosperity, the Shanghai and Shenzhen stock markets provide financing and refinancing opportunities to various enterprises, but when the industry is not thriving, they are at a loss regarding the rising net asset values of these companies' shares. Some securities analysts have issued buy ratings on some stocks with rising net asset values and attributed it to market irrationality. I believe this is due to errors in their stock valuation methods. These companies have negative error terms and possess superior genes, so they should be eliminated or acquired by companies with superior genes rather than allowing investors to buy them.

If viewed from the perspective of scientific development, there should be an entirely different mechanism. People should not encourage companies to compete on size or start small projects, but instead, encourage excellent companies to use share swaps to acquire the assets of other advantageous companies, equipping the best "hardware" in the market with the "software" that can be purchased in the market for management. This is the path to achieving scientific development. Forming such a mechanism is not difficult; the challenge lies in the fact that every place has its own interests and is unwilling to let others operate their local enterprises. This is a deeper-level issue and also an urgent problem currently faced by the stock market. In mature foreign markets, professional mergers and acquisitions are common, whereas in the Shanghai and Shenzhen stock markets, additional issuances are more frequently seen, which does not conform to the rational development view.

The cornerstone of the stock market is the correct valuation method and the valuation system derived from it. We must establish a correct valuation method based on the scientific development concept and accordingly form procedural guarantee mechanisms, thus solidifying the foundation of the Shanghai and Shenzhen stock markets.

Additionally, there is another viewpoint suggesting that state-owned enterprises do not need to distribute dividends or can distribute minimal dividends, keeping profits within the enterprise benefits the development and strengthening of state-owned assets. Those who proclaim this view are likely large shareholders of the enterprise. They even cite foreign theories about "dividend policy affecting stock prices." The principle that dividends do not affect stock prices is valid in foreign markets because these mature markets have established relatively perfect corporate governance systems. Enterprises have formed stable quarterly dividend policies, so the market is not sensitive to non-dividends. We cannot currently invoke this principle because we cannot confirm that we have already established a perfect corporate governance system, and the majority of A-share listed companies do not have fixed dividend policies.

Leaving funds in the enterprise may involve tax avoidance considerations, but why are these companies unwilling to repurchase their own shares? If the Ministry of Finance is willing to exempt capital gains taxes and allow A-share investors to enjoy B-share treatment, distributing a large portion of the annual distributable profits to investors can not only stabilize the market but also play an incentive and supervisory role for the company's management. Thus, domestic investors can share the economic results of reform and opening-up through the stock market, contributing to the establishment of a harmonious society.

These high-dividend-paying enterprises, under strict corporate governance constraints, will undoubtedly receive high valuations in the capital market. If the company has a refinancing plan, it will inevitably gain market favor and issue stocks at a high valuation, thereby reducing financing costs and ultimately benefiting the development of state-owned enterprises and the appreciation of state-owned shares. Historical experience tells us that when a listed company has a small amount of cash and is unwilling to return it to shareholders, it is often the time when the company begins to misinvest, blindly expanding industries and making aggressive external investments, which do not conform to the requirements of the scientific development concept. Returning accumulated profits quickly to shareholders actually imposes higher requirements on the use of funds by listed companies, promoting enterprises to use capital more reasonably and efficiently.

A stock market that can genuinely reward the majority of ordinary investors will undoubtedly play a key role in the country's macroeconomic stability. To establish a domestically demand-led economy, China must achieve a better scientific development concept and increase residents' property income, which can generate wealth effects in China and attract more domestic investors to support the great cause of reform and opening-up.