This activist investor's Hong Kong stock rout prediction was spot on

Investor David Webb issued a report titled "The Engima Network: 50 stocks not to own"

Six weeks ago, David Webb, an activist investor and former director of the Hong Kong exchange, issued a report titled "The Engima Network: 50 stocks not to own". On Tuesday, most of the shares he named abruptly plunged, pointing to chronic regulatory problems over small-cap shares in the Asian financial hub.

Webb's report mapped out a complex web of cross-shareholdings between companies listed on both the main board and its sibling, the Growth Enterprise Market, which he said created a breeding ground for volatility.

Tuesday's biggest decliners showed characteristics that have long worried regulators and which Webb highlighted in his report: high shareholding concentrations, unrealistic valuations, and complex relationships between companies and listed brokerages.

The Hong Kong government and regulators are growing increasingly concerned that a series of company scandals, many of them centred on mainland companies listed in Hong Kong, have tarnished the territory's reputation as a financial centre as it marks the 20th anniversary of its handover to China this weekend.

Webb, a successful investor and author who studied mathematics at Oxford, told Reuters on Wednesday he had come across the network through his own research into annual reports and company disclosures.

"I picked up on this network years ago when they started building it. The meltdown shows these stocks are closely related," he said.

His report only covers cross-shareholding relationships but the companies also have many directors in common as well as related transactions, Webb said.

The purpose of such networks, Webb said, "is to defraud investors - extract and misappropriate money and part of that involves manipulating stocks."

'DUMP AND RUN'

Webb, an outspoken critic of the Hong Kong market since he quit the HKEX board in 2008, said it was unclear what triggered Tuesday's sell-off.

"I can only speculate. But it's possible margin calls have been triggering the sell-off. It's possible the brokers involved have been told to stop lending against those shares ... Maybe the people operating the network have decided to dump and run."

Webb said he never shorts Hong Kong shares.

"The bigger picture here is that this again reminds us that the current regulatory system is not working and these problems have been allowed to build up by the Hong Kong exchange (HKEX)." He also blamed the independent market regulator, the Securities and Futures Commission (SFC), "for not stopping it."

An SFC spokesman declined to comment on whether the regulator was investigating any of the companies in the network.

In a statement, the SFC said: "The stocks which have experienced large price declines yesterday occupy a market segment characterised by thin turnover, small public floats, high shareholding concentrations, and multiple relationships between different companies and listed brokerage firms. These characteristics can be especially conducive to extreme volatility and also to market misconduct."

The exchange denied speculation on Tuesday it was planning to delist thinly traded shares.

WLS Holdings, which had a market value of HK$409 million, was the biggest loser on Wednesday with its shares sliding 47 percent, while Greater china Professional Services Ltd. dropped 34 per cent after a 93 percent drop on Tuesday.

REFORM IDEAS

Webb said he opposed a recent HKEX proposal to add a third board, catering to start-ups, and argued the two existing boards should be merged and put under the jurisdiction of the SFC.

The investor activist said Hong Kong also needs a class action legal provision so investors can hold boards accountable. He said all companies should be compelled to file results on a quarterly basis, with restrictions on how much companies can invest in other stocks.

Webb, a member of the SFC's takeover panel, has been a thorn in the side of the establishment and Hong Kong's mega-rich business elites through his public commentary and eponymous "Webbsite" for much of the past 26 years he has been resident in the city.

Last year, however, Webb told readers of his newsletter he would dial back his commentary and public activism in frustration that his efforts had yielded little change in the financial hub over the years.

The HK$28.6 trillion ($3.7 trillion) market has grown nine-fold since the former British colony reverted to China rule in 1997, largely on an influx of listings from mainland firms. They now make up two-thirds of market value and represent 90 percent of the funds raised from IPOs in the five years to 2016.

Investors seem to discount the market, with the Hang Seng index trading at around 14 times earnings, versus 22 times for world stocks and 23 times for US equities.

The SFC, along with the Hong Kong stock exchange, have issued several warnings over concentrated shareholdings in penny stocks listed on the GEM. The average first-day price rise for a GEM company debut during the first half of 2016 was 454 percent due to such concentrations, SFC data shows.

This month the HKEX launched a wide-ranging consultation to try to address this problem, including a proposal to raise the minimum market capitalization by 50 percent to HK$150 million and increasing the cash flow requirement for initial listings.