Wednesday, June 1, 2011

How can Unleashing Non Free Float Shares Impact the A-share Market

It is well-known that A-share market has been under selling pressure due to huge amount of non free float shares being unleashed especially after 2008. The real reason for continual selling was basically because these unlocked shares were offered at a very low exercise price even compared to the current share price levels.

Investors in A-share market have indeed been highly nervous about any related news, though sometimes they appeared to be quite irrational. For example, on 30 November 2010 morning trading time, the China Ministry of Finance announced to adjust and expand a capital gains tax of 20% on the sale or transfer of restricted shares. Holders of restricted shares through mergers or inheritance would then be required to pay the tax on each transaction. The benchmark SSE Composite index tumbled more than 3% to 2779 at the morning close, as investors were scared by the factors of the increase in selling costs and extraction of capitals from the market.

Here in China there are really many opinions and debates on how the unlocking of non-free float shares should affect the market, but none of them can tell exactly how many index points should drop if a certain amount of non-freefloat shares become freefloat. Honest to say, without a good estimation on its exact impact, it is more than unlikely for anyone to set by calculation a reasonable target for Shanghai SSE Index. Is it, however, really impossible to quantitatively measure its exact impact factor?

While you might not be aware of, a new Shanghai SSE Free Float Index (index code: 000090) was already launched quietly on 2 December 2010. Here is what Shanghai Stock Exchange tells you about the SSE Free Float Index: SSE Free Float Index is composed of all A-share listed on Shanghai Stock Exchange (SSE), except those stocks which have not undergone or completed their non-freefloat share reforms and those stocks which are being suspended from listing, and is weighted by freefloat factor adjusted market capitalization. SSE Free Float Index not only measures the price movements of freefloat A-share listed on SSE and thus provide investors with new performance barometer of the Shanghai stock market, but is also designed to serve as a new investable underlying instrument for potential index adjusted products. The base date of SSE Free Float Index was 31 December 2009 with a starting base index of 1000. On its first trading day, the SSE Free Float Index closed at 944.

What the Shanghai Stock Exchange did not tell you is that, by comparing the annual performance of the Shanghai SSE A-share Index with the new SSE Free Float Index:

31 Dec 200931 Dec 2010% change
SSE A-share Index34372940-14.5%
Total freefloat capitalization (RMB trillion)11.414.1+23.7%
SSE Free Float Index1000924-7.6%

(Market Data Source: Shanghai Stock Exchange)

The SSE A-share Index dropped by 14.5% during the period, but the new SSE Free Float Index dropped only by 7.6%. It was something that we could understand, since the total freefloat capitalization raised by 23.7% on the same period. It means even the share price fell, the SSE Free Float Index level could be maintained if there was a sufficient increase in the number of free float shares. By simple mathematics, the extra percentage drop is calculated as: [1+(-14.5%)]/[1+(-7.6%)]-1 = 7.4%. That said, the SSE A-share Index had to adjust by -7.4% just for keeping the SSE Free Float index level unchanged when there was a 23.7% increase in the total freefloat capitalization during the period. In a more simple presentation, any 10% increase in the total freefloat capitalization alone could induce a -3.1% adjustment in the SSE A-share Index!

Sound easy to calculate? Now we can estimate quantitatively the impact of any additional freefloat capitalization to the SSE A-share market, as well as estimate its impact to the benchmark SSE Composite Index simply by adding the B-share capitalization, because the SSE Composite Index includes both the A-share and B-share capitalization.

Please also note the following related useful market data:

(1) According to SSE data, ratio of non-freefloat market capitalization (not yet unleashed; i.e.: still outstanding) was reduced from 37.8% in end-2009 to 20.5% in end-2010. Price/Earnings (P/E) ratio of A-share was also adjusted from 28.8 times to 21.6 times during the same data period.

(2) The total freefloat capitalization on 31 December 2010 was already 2.1 times the level when SSE Composite Index and SSE A-share Index were at historical high 6124 and 6430 respectively on 16 October 2007. At that peak-level, the total freefloat capitalization of Shanghai market was only RMB 6.6 trillion. We can say the real reason of Shanghai stock market crash during the period was mainly due to the rapid rise in freefloat capitalization, not the global financial tsunami.

In conclusion, the impact factor of non free float shares being unleashed will continue to annoy everyone in the Shanghai A-share market but we believe our above efforts should help our readers to estimate its exact impact and overcome this headache by just simple calculations.


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