Stock Exchange Showdown

Back to Contents of Issue: March 2000

by Bradley Martin

Talking about wild rides, consider just one day: Wednesday, January 5. At the end of that day's trading session on Tokyo's two-week-old Market of High-growth and Emerging Stocks, or "Mothers," shares of Internet Research Institute were up by the daily limit of ¥2 million. That meant they were priced at ¥59.21 million each -- more than five times the ¥11.7 million at which IRI had priced its initial public offering on December 22. Total trading volume in IRI on that Wednesday: 182 shares.

The same day, Mothers' other listed share, Liquid Audio Japan, took its cue from the worst point loss in history on the US Nasdaq composite index to move in the opposite direction; 54 -- count 'em, 54 -- shares of the company changed hands by the time the stock had dropped its daily limit of ¥1 million. That hemorrhage took IRI to ¥5.46 million per share, 9 percent below the ¥6.1 million to which traders had bid it up before it changed hands the first time on Dec. 24 -- but still almost twice the IPO price of ¥3 million.

So it goes on Mothers, the Tokyo Stock Exchange's answer to competitors' plans to start a Japanese version of Silicon Valley's fund-raising venue of choice for high-tech startups, Nasdaq. Japanese press comments from the start of trading called Mothers' prices "overheated." The TSE's Hiroyasu Shirahashi, head of listing policy planning, when asked on the second day if they were higher than he expected, replied: "No comment."

But because of the way Mothers was set up -- and the way Nasdaq Japan is likely to be set up, and the competition between them -- the question posed by investment professionals from the start has been bigger, a question that transcends the fate of any particular companies' shares: Are the new exchanges going to be a durable answer to the prayers of formerly capital-starved entrepreneurs? Or due to illiquidity - in layman's terms, scarcity of shares to buy or sell or both -- will their credibility take a major hit as they soon prove too disappointing to investors?

"This is a liquidity-driven bull market in 'new economy' stocks. This is very crazy, feverish," says one critic, Simon Ross, fund manager at Tokyo's AIMIC Investment Management, a subsidiary of AIG of the United States. "It's a nice game, but unfortunately there are going to be some people holding the bag at the end of the day -- and they're not going to be my investors."

Ross has a point. Really, how could an inexperienced and little-known consultation and technology-outsourcing company such as IRI be worth ¥782 billion, its total capitalization (price times number of shares) on January 5? How could a money-loser such as Liquid Audio Japan -- which reported no sales at all in the July-September quarter -- be worth more than ¥70 billion?

Could those outlandish figures just possibly have to do with the fact that practically the entire market would like to be in a position to buy some of the mere handful of shares of each company that are "available" to the public? It's a fact that one or the other stock can go for days "bid only" or "ask only" with no shares actually changing hands as buyers or sellers await more favorable prices.

Then again, one might ask, how could an Internet service provider, America Online, be worth enough to absorb -- OK, OK, "become the majority partner in a merger with" -- Time Warner? Doomsayers understandably have been having a hard time getting people to heed them throughout the Internet stocks boom that has swept the United States and now has migrated to Japan. A lot of money rides on the hope that they are wrong in their assessment of Mothers.

But just in case it does turn out -- days, weeks, or months down the road - that too many people get left holding the bag with shares they've wildly overpaid for, the currently white-hot enthusiasm for startup ventures' shares and for the new exchanges listing them could cool down considerably.

There is a precedent in the government's sale starting in 1986 of shares in then-state-owned Nippon Telegraph and Telephone. NTT had poor earnings prospects. But the Ministry of Finance, which was unloading the government's shares, rationed them out in relatively small numbers to keep them scarce and drive the price up. MOF needed the revenue to balance the budget. More than 10 million people -- twice as many Japan residents as then owned shares of any company -- applied for an initial lottery to determine who would get to buy NTT shares at the IPO price of ¥1.12 million.

As the lucky winners resold their shares the price rose astonishingly, to ¥3.18 million in the first nine weeks. At one point NTT was worth, on paper, more than all the companies on Germany's stock markets combined. One writer at the time described the enthusiasm for owning NTT shares as "reminiscent of an earlier national passion for koala bears." Then the national bubble burst and the market crashed, NTT with it. For many an ordinary Japanese household, an NTT share certificate became a symbol of the dark and malevolent forces at work against ordinary participants in the market -- and a lasting reminder not to get involved again.

NTT, of course, is vastly different in scale from startups listing on Mothers. Still, TSE officials do not rule out the possibility of an NTT-type pattern in trading on Mothers.

"I hope not, but nobody can predict," chief listing officer Jun Shimizu said in an interview before trading began. And Hiroki Kawai, deputy manager of the TSE's Strategic Policy Group, added: "The environment is too good. The minds of investors -- especially small individual investors -- are heated up now for Mothers." That went for institutional investors as well. The ones Kawai visited said, "I want to buy! I want to buy!" he recalled. "So I'm afraid the opening price will increase sharply and after that come down. It's the NTT type, I'm afraid."

It hadn't happened by the time this magazine went to press. But if the NTT pattern does get repeated to the point the new exchanges become the scene of a fiasco, poisoning the well of investor confidence, then would-be builders of businesses conceivably could find themselves right back where they started: standing in line at banks' loan counters, having not even a prayer of getting listed on a major stock exchange.

A major goal in setting up Mothers, says the TSE's Shirahashi, was to give newly emerging businesses an alternative to reliance on banks. Japanese banks traditionally had taken very strong, sometimes suffocatingly overpowering, positions in the companies they financed. And that was if they even deigned to get involved at all -- which they usually didn't when it came to real startups.

So where were the venture capitalists all that time? "One of the reasons behind the narrow breadth of the stock market has been the limited availability of investable, high-quality growth companies," says Kathy Matsui, chief strategist for Goldman Sachs in Tokyo. And a major problem of access to financing, she says, has contributed to that scarcity. "The absolute amount of risk capital available in Japan has been extremely limited, with the amount of venture capital in Japan roughly one-eighth that of the amount in the US."

The Ministry of International Trade and Industry (MITI) counts fewer than 200 VC firms in Japan, versus over 1,000 in the US. And even when money was available, notes Matsui, "the majority of Japanese venture capital has tended to be invested into companies relatively late in their development -- typically at least 10 to 20 years after incorporation, while in the United States the bulk of venture capital tends to be invested in the earlier stages of development."

The bottom line until now is that it has been "extremely difficult for Japanese startup or venture firms to gain access to necessary capital. A case in point is Internet Initiatives Japan, which was the first Japanese company to list on Nasdaq in the US without first listing on a Japanese exchange."

Matsui has studied Germany's new small-caps bourse, Neuer Markt, which she calls "a successful example of how new exchanges can channel capital efficiently into the hands of young growth companies." Neuer Markt, she says, "brought an end to the longtime shortage of venture capital in Germany by filling in the financing gap that banks could not fill." In the process, "it has also given initial investors a natural exit strategy that previously did not exist."

Mothers seeks to do something similar -- as does Nasdaq Japan. Major Japanese stock exchanges haven't been much help to money-starved entrepreneurs. To be listed on even the weaker Second Section of the Tokyo Stock Exchange requires a company to have been incorporated for at least three years and to show at least ¥400 million in ordinary profit for the latest year. Those are impossible hurdles for a startup company that has yet to see any profit whatsoever.

Mothers makes things far easier for newcomers, requiring of them no profits and no history. Companies can be deep in the red if they are in high tech or other hot new fields and show promise of success. "We don't consider their past achievements," says Shirahashi. "It is a drastic deregulation."

Indeed. Liquid Audio Japan, local affiliate of an American company that makes systems for transmitting music over the Internet, lost ¥306 million after tax (and had sales of only ¥52 million) in the fiscal year through June, its first in business. And IRI, which designs information systems for the Net, although it dates all the way back to December 1996, made only ¥63 million on sales of ¥725 million in the fiscal year that ended June 30.

To make the case that they offer the promise of success despite their newness and poverty, companies seeking listings on Mothers must provide more extensive disclosure than is asked of those listing on the established TSE First and Second sections. The requirements are also tougher than those on the over-the-counter (OTC) market operated by the Japan Association of Securities Dealers, which in the past has been the principal listing haven for small-cap startups.

Requirements on Mothers include a quarterly financial report, covering not just sales -- as the OTC requires -- but profit-and-loss status. And listed companies are required to hire CPAs to review not only their first half and annual reports, as is required by law, but their first- and third-quarter reports as well. "We think this may appeal to foreign investors," Shirahashi says.

Additionally, the companies are required during the first three years after their IPOs to hold explanatory meetings for investors three times a year. "We will prepare a presentation room," promises Shirahashi. But just imagine what the presidents of First Section TSE-listed companies would think of this responsibility. Many of them already are terrified of their annual shareholders' meetings and the sokaiya racketeers who attend to try to embarrass them publicly.

Clearly Mothers-listed companies' executives will need to be of the new breed, laid back in the Silicon Valley/Bit Valley mold and ready to spar verbally with any querulous shareholder, in order to flourish in the face of all these demands for corporate transparency.

It's regarding mainly liquidity, rather than disclosure, that the new Japanese market has aroused concern among professional investors. Matsui of Goldman Sachs notes that Germany's Neuer Markt requires that the free float of shares be at least 20 to 25 percent of total. Although she's "very positive . . . in principle" regarding the new Japanese exchanges, she faults Mothers for failing to set such a minimum -- and notes that Nasdaq Japan draft requirements seen so far are similarly lacking. With nothing to stop them, companies float very small numbers of shares and "the market becomes very illiquid."

Analyst Craig Nelson of Dresdner Kleinwort Benson feels illiquidity will be "an issue" for both of the new Japanese bourses. "The amount of shares actually issued is going to be small compared with the total number outstanding. So trading in them is going to be difficult for large institutional investors." Since Mothers has no requirement regarding minority or special interests, says Nelson, "99 percent of the shares could be held by a small number of people."

AIMIC's Ross was one of many investment professionals who saw the "go-go fever" coming. "Mothers is thematically echoing the hunger of individual investors," says Ross, who buys shares in Japanese companies for a $150 million mutual fund, "The Japan Capitalist," which is sold to residents of Japan.

Huge numbers of individuals had responded to the market's miserable performance from the time the bubble burst a decade ago by keeping their money parked in bank accounts and postal savings, Ross notes. But eventually, older Japanese who had experienced the stock market in the boom period became restless over the pitiful interest rates their assets were earning. "Mom and Pop were sitting with lots of cash under mattresses, terrified by the prospect of wealth-dilution."

By the end of 1999 this older group already had mobilized much of its savings to jump back into the market. But Ross says there is "lots of money still in the Post Office," in instruments with maturity dates as late as 2001. In particular, "we still haven't unlocked a lot of the power in the 30s-to-40s age group," people too young to have had positive investing experiences in the pre-bubble days.

Both experienced and inexperienced investors this time are actively looking for growth rather than simply relying on reassuring old-line company names, and "Mothers is attracting these supposed high-growth companies," Ross says. "In Japan, when you haven't seen growth in a long time, you get a little feverish," he adds. Sorting out good companies from bad in the Internet boom will take some time. "You already have companies with mediocre business models trading at outrageous multiples, simply because there's no supply. So where we are is like the US of, say, four years ago, when anything went up."

Such a situation is, of course, "great for venture capitalists, great for entrepreneurs kicking their stock into the market," who are happy to find a window of opportunity while they're hot. Besides providing capital for expansion, listing values their companies in the market. That not only makes the entrepreneurs rich on paper (and rich in fact, if they sell some of their own shares during the frenzy) but also can be very useful whenever someone wants to buy them out or merge with them.

But the question is how long it can last, says Ross. "In the long run, stocks are traded at a discount if they're illiquid. This market should really trade at a liquidity discount - but it first will have to start at a liquidity premium."

A big factor behind the liquidity problem is that entrepreneurs, naturally enough, want to have their cake and eat it too. They want investors' money -- but they don't want to give up much of their equity in exchange. Liquid Audio Japan and Internet Research Institute each issued only 1,000 new shares, out of totals of 13,000 and 13,210 shares outstanding, respectively, after the IPOs. Insiders kept the rest.

Mothers does require that a company, to list, have at least 300 public shareholders -- but that doesn't help the general run of investors. "In pre-IPO, at best you're lucky if you get a share," says Ross. "Underwriters have allocated at least 60 percent to the individual market. If you're not a big customer of broker X you don't get diddly squat." Institutional investors at the outset could not get "even one share," so they were sitting back and waiting. "Really it's a market for the big clients of brokers, who get it at 10 and sell it at 50."

Before the IPOs, Ross predicted that the price of one of the newly listed companies' shares "could go up three to four times before it even changes hands the first time." In the event, IRI went up 4.5 times. But huge jumps like that are not unheard of with high-tech IPOs on other markets, including the Japan OTC. Yet to be seen is whether Ross was right with another, ominous prediction: "You'll get a parabolic move -- everyone will realize it's illiquid and the market will have a major correction."

Ross believes that the TSE in setting up the Mothers system was mainly looking, with the encouragement of some large Japanese brokerage firms, for the fastest way to start attracting companies and get them listed before Nasdaq Japan could gear up for operations.

Softbank, chaired by Masayoshi Son (who was born in Japan with Korean nationality but is now a naturalized citizen) threw down the gauntlet last June by announcing it was forming a joint venture with the US National Association of Securities Dealers to set up a Japanese version of Nasdaq. Since then, Ross asserts, "there's a lot of face-saving going on at the TSE on Mothers vs. Nasdaq Japan, which they view as 'not made here' -- and hatched by a Korean at that."

"Mothers' market capitalization has to rise significantly to get a foothold lead before Nasdaq Japan comes on stream -- a matter of national pride," suggests Ross. "As such, the supply of stock on Mothers has been kept semi-purposely tight to pump up the capitalization. Classic Japan -- do something before the black ship comes into Shimoda." He adds that "the Tokyo Stock Exchange put out feelers to encourage thematically correct high-growth companies to list on Mothers sooner, rather than waiting for Nasdaq."

Is so much cynicism justified? Not according to Tokyo Stock Exchange officials. They acknowledge they are in a hurry to attract a lot of companies to list on Mothers and give the new section credibility. However, they explain it not in terms of nationalism but as a simple matter of strong competition with Nasdaq Japan. "If we can have many companies in the Mothers market and have an established market, applicant companies may choose Mothers rather than Nasdaq Japan," says Shimizu. "That's one of our hopes."

Since rolling out its alternative to Nasdaq Japan, the TSE indeed has fought back with fierce competitiveness, sending executives to persuade companies to list on Mothers instead of waiting for Nasdaq to develop its system. One of their arguments has been that the TSE already has its systems in place. "We have a reputation for operating a secondary market," boasts Shimizu. "We have established a clearing system and trading systems. We have people for monitoring stock price movements and requesting timely disclosure. . . . We have about 40 years' experience doing such things."

Shares listed on Mothers trade on the same system that handles the first and second sections of the TSE; the only difference is in listing requirements. The trading system has been totally computerized since the old TSE trading floor was closed last year.

Adding the Mothers stocks didn't require any reprogramming of the trading system, TSE officials boast. But actually it seems the computer system was not totally ready. According to a Kyodo report, TSE announced on December 20, two days before the start of trading, that it was limiting the first-day price of IRI to ¥20.7 million. The exchange usually permits a new listing to double on its first day, if the market so decides. But its system was not prepared technically to handle a full doubling from the offer price of ¥11.7 million to ¥23.4 million.

The TSE system enables shares to be priced through a computerized auction. Nasdaq Japan, on the other hand, is expected to use a hybrid system incorporating both auction and "market-making," in which broker "specialists" help figure the value of stocks.

The TSE's Shirahashi says market-making used on the Japan OTC proved unattractive to Japanese traders and he predicts that will also be the case with Nasdaq Japan. The market-making system is "very difficult to be adopted in Japan," because of inexperience, he says.

Also, he notes, securities companies involved in making the market for a particular stock need to keep some of its shares in reserve or acquire them from the market. This requirement tends to mean that only major brokerages will make markets, in the cases of most stocks. "Who will be the major securities companies for market-making?" Shirahashi asks. "Whoever they are, they have to have sufficient expertise. It might work if foreign companies like Merrill Lynch took it on, but the foreign companies in fact are mainly wholesalers. So the reality is, market-making falls on Japanese securities companies -- and people worry about their skills. Japanese institutional investors say the auction method is better."

But Shirahashi adds: "We ourselves don't think auction is the perfect method." Mothers, he says, will introduce in the spring a system modified in some as yet unannounced way. He's vague about it but the auction system works best when there are set regular dealing hours, when there is likely to be sufficient volume. If exchanges go to after-hours trading, a more flexible system may be needed, it seems.

Nasdaq Japan, whose promoters have been citing flexibility as one of its advantages, is scheduled to join with the US Nasdaq and Nasdaq Europe in a move to 24-hour global trading. Probably mainly for that reason, some US Nasdaq stocks with global followings are to be listed eventually on Nasdaq Japan. The TSE says it sees little demand for 24-hour trading of venture companies' shares. But -- ever alert to competition - it hasn't ruled out extending its own hours, especially for globally traded First Section stocks such as Sony and Toyota.

Market participants for some time were concerned, according to TSE officials, that it was impossible to know just what sort of system would finally emerge at Nasdaq Japan. That argument lost some of its punch with the December 24 announcement of a tie-up with the Osaka Stock Exchange. The OSE, for a share of profits, will set up a new market within its operations, separate from its First Section and Second Section. It will also screen applicants for listing and provide settlement, trade-clearing, and other services -- plus a communications network that Nasdaq Japan can use to communicate with some 100 participants in the market while it builds its own Internet-based trading system.

The deal will reduce Mothers' head start by letting Nasdaq Japan start trading some stocks -- Japanese IPOs and US companies that have Japanese subsidiaries - as early as June or July, half a year earlier than originally planned.

The Osaka tie-up announcement also took some of the bite out of another argument in favor of Mothers -- that Nasdaq Japan after its initial announcement had more or less faded back into the woodwork, saying and doing little to let the world know it was alive and preparing to launch. "They started a working committee in the summer but it stopped functioning from September," is the way Kawai put it in an interview a few days before Son and the OSE came back with their big announcement.

Another jibe: The Nasdaq Planning Company has had only three full-time staffers, "so [TSE] member firms say they have no ability to proceed with this project," according to Kawai. Indeed, the Nasdaq planners continue to keep too quiet for the taste of some people. As Matsui of Goldman Sachs observes, "All eyes are now on Nasdaq Japan and how the link with the OSE will be different from Mothers. Not much detail is available yet." (Nasdaq Japan planners declined to be interviewed for this article, although one answered a few quick questions over the phone.)

At any rate, Shimizu insists, success for Nasdaq Japan would not be a disaster for the TSE. Just the opposite. "It's not whether we are winning or not. If the Nasdaq companies are successful, we will have the opportunity for more big companies to be listed" -- on the First Section of the TSE. It's true that some US companies such as Microsoft and Intel make it a point of loyalty to remain with Nasdaq even though they are hardly small caps any more. But Japanese companies that can meet the listing requirements, Shimizu predicts, will want the prestige of moving on from Nasdaq Japan -- or Mothers, for that matter -- to the TSE's First Section.

Quite a few big companies that were listed on the Japan Securities Dealers' Associa-tion OTC board made the switch in 1998, says Shimizu. During listing examinations, when asked why they wanted to move, they typically answered that the president of a big company naturally wants his success validated with a First Section listing.

Maybe so, but if Nasdaq indeed offers 24-hour trading, even some First Section TSE companies may consider jumping the other way.

Asked about one of the biggest problems critics see in their listing requirements, TSE officials say the public floats of only a few shares are a natural outcome, to some extent, because entrepreneurs want it that way. Also, "we were not sure so many institutional investors would be interested in investing in the Mothers market," Shimizu says blandly.

But there are legal reasons as well, and TSE officials say they hope the government will deal with those. The main legal problem is a 1982 provision of the Commercial Code that forbids trading in units of less than one share and requires that companies set the par value of each individual share at ¥50,000 -- instead of the ¥50 that is common among older companies. (NTT was one of the early companies to list with 50,000 par value and one share instead of 1,000 shares as the minimum trading unit.)

Thus a single share of one of the new companies, such as Liquid Audio Japan or IRI, may be equivalent in par value to 1,000 shares of an older company. One thousand shares of a new company -- the minimum public float on Mothers and the number in fact floated to the public by both Liquid Audio Japan and IRI -- is equivalent to a million shares of an old company. Mothers' minimum public float of 1,000 trading units in fact is larger than the 500 trading-unit minimum on the Japan OTC market.

But the Second Section of the TSE requires that a company's "stable" shareholders, including the founders, hold under 75 percent of total shares issued, with at least 25 percent freely traded by the public. The decision not to impose such a regulation at Mothers, TSE officials say, was based partly on the small size of the companies involved, which in many cases are the creations of single entrepreneurs. "We are dealing with emerging companies, still in the growth stage," says the TSE's Shirahashi, head of listing policy planning. "If we imposed that sort of restriction, we felt it would hinder growth."

Shirahashi says he thinks it will be necessary to reduce the size of minimum trading units to provide greater access to trading and resulting higher liquidity. "Obviously if the IPO value of a company is ¥10 or ¥20 million a share and you can't buy anything less than one share, that's a barrier to most individual investors," he says. "It's something that not only we but Nasdaq Japan and others should be thinking about."

The TSE planners say they hope to see sales of fractional units permitted, and say officials at MOF and MITI are already talking about the possibility. (Both ministries declined interview requests.) "They are already aware of the problems. Ultimately it will be an issue of whether to revise the commercial code." Meanwhile, "all we can do is ask companies to offer stock splits."

AIMIC's Ross thinks Nasdaq Japan would be smart to use the liquidity issue against Mothers and offer a more equitable system. But judging from a draft circulated before the Nasdaq-OSE announcement, there may not be much difference between the two markets in listing requirements. Based on the listing requirements of Nasdaq in the United States, Nasdaq Japan's would require that at least 500 new shares be issued to the public in a float. That number is regardless of the number of existing shares outstanding, so the requirement is more or less meaningless.

Nasdaq Japan's draft does include a requirement that the market value of a listing company be at least ¥5 billion -- while Mothers' minimum is only ¥500 million. But the TSE doesn't expect that, in practice, companies as small as ¥500 million will be listing, says Shirahashi. Experience so far bears out that prediction: Liquid Audio Japan and IRI obviously would have had no trouble meeting the Nasdaq Japan minimum.

Anyhow, there is as yet no Nasdaq Japan. And for their first few weeks, at least, notes Matsui, Mothers' first two listed companies "have maintained relative strength in their share prices. There are many complaints from investors about lack of liquidity, which hopefully future listings will resolve. But remember, most new markets such as these have experienced growing pains of one form or another. I think Japan will be no different."

Meanwhile, companies "have nothing to lose" by listing on Mothers, says Ross. And if the initial pattern holds, of course, they have much to gain. Thus TSE officials expect an additional four to five companies to list on Mothers by March and another 20 to 30 between April and December.

Will some of those, as Ross and others fear, end up killing the goose that laid the golden egg? Or does this young goose still have a long and productive laying career ahead of her? Take your pick. While optimists like to think demand will be sustainable, Ross says, "at the end of the day markets are always right. Stocks always get valued within an acceptable range of fair value." On the other hand, as he notes regarding the worries over liquidity, "Professional investors are concerned -- except those running with the flow."

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