Hong Kong small-caps: ready for China fever?

Yangtze Optical Fibre and Cable Joint Stock Co

27/09/2016 24:00

* Chinese may make up 1/3 of HK trading turnover in 3 years 
    * Chinese small-caps 4-5 times dearer than HK peers 
    * Chinese inflows driven by yuan fears, yield hunt 
    * Potential for culture clash, but likely to converge 
 
    By Samuel Shen and John Ruwitch 
    SHANGHAI, Sept 27 (Reuters) - Chasing higher returns in a 
slowing economy, Chinese investors could soon dominate Hong 
Kong's stock market, likely redefining how shares, especially 
small-caps, are traded and priced there. 
    Chinese money will account for a third of Hong Kong's stock 
trading turnover in three years, up from a tenth now, UBS and 
other brokers predict. Some traders say it could hit 50 percent 
within five years. 
    That would be a sea change for Hong Kong's century-old stock 
market and a serious challenge to western players. European and 
U.S. investors now account for almost a quarter of stock 
turnover. 
    Fund managers say the inflow of Chinese money will be driven 
by deregulation, fears of yuan depreciation, and yield chasing 
as there are still wide valuation gaps between the two markets. 
    The shift could trigger a culture clash between 
fundamentals-dependent western investors and momentum-driven 
Chinese, who tend to be more aggressive and speculative. 
    It is likely to be most evident in Hong Kong's small-caps, 
as the opening of the Shenzhen-Hong Kong stock trading link, as 
early as November, will allow mainland Chinese to buy Hong Kong 
small- and mid-caps, bringing much-needed liquidity, but also 
likely speculative fever to growth stocks. 
    "Small-caps in Hong Kong have long suffered from poor 
liquidity ... and low valuations. Mainland investors have a 
penchant for growth stocks, often giving them stretched 
valuations," said Lu Wenjie, strategist at UBS. 
    "Mainlanders also like stir-frying concept stocks. A growth 
story with a 5-year horizon is often priced in just a week in 
China. Such an investment style will have a big impact on Hong 
Kong stocks." 
     
    MIND THE GAP 
    In blue-chip stocks, the price gap has already narrowed, 
with China-listed shares around a fifth more expensive than Hong 
Kong  .HSCAHPI , as Chinese investors have bought stocks like 
HSBC  0005.HK , Tencent  0700.HK  and ICBC  1398.HK  via the 
already open Shanghai-Hong Kong Stock Connect scheme.  
    The Shenzhen-Hong Kong link will offer a broader investment 
scope. 
    "The valuation differentials between Shenzhen and Hong Kong 
small-caps are pretty significant," said Kinger Lau, chief China 
equity strategist at Goldman Sachs. 
    China's small-cap companies trade at over 40 times expected 
earnings, the highest in Asia-Pacific, and four times the ratio 
in Hong Kong. 
    The arrival of Chinese investors, who on average trade eight 
times more frequently than their Hong Kong peers, will likely 
increase market turnover, volatility and, potentially, the 
number of insider trading cases. 
    "Investors are very clever. They will bring to Hong Kong 
some of the Chinese style, but will also learn about the new 
environment [such as short-selling and additional share 
issuance] and adapt," said Fu Xuejun, strategist at Huarong 
Securities. "I don't think they'll be as crazy as they are in 
China." 
    Bourse operator Hong Kong Exchanges and Clearing Ltd 
 0388.HK  said it does not have details of fund flows from the 
mainland, and does not speculate on future market activity. 
             
    FUNDS FRONT-RUNNING 
    Anticipating a re-valuation of Hong Kong stocks once the 
Shenzhen link opens, some Chinese fund managers are already 
building up stakes in select stocks to front-run mainland money. 
    Shen Weizheng, Shanghai-based fund manager at Ivy Capital, 
said he has bought shares in Hong Kong-listed Yangtze Optical 
Fibre and Cable  6869.HK . "Water flows from high places to low 
places, naturally. Once the floodgate opens ... liquidity will 
flow south ... narrowing the valuation gaps," said Shen, who 
manages a $1 billion offshore fund that has 70 percent of its 
portfolio in Hong Kong stocks. 
    He noted Yangtze Optical Fibre trades at around 10 times 
earnings, while its China-listed rival Hengtong Optic-Electric 
Co  600487.SS  trades at three times that. "It's natural to buy 
cheaper assets," he said, noting the stock has jumped by more 
than a third since Beijing approved the Shenzhen link last 
month. Shen said the stock could gain another 50 percent as 
optic-fibre is a popular concept among mainland investors. 
    Shanghai-based hedge fund RPower Capital has also increased 
its bets on Hong Kong stocks, said Robert Di, founding partner. 
"Chinese regulators have stepped up a crackdown on speculation, 
so many domestic hedge funds are starting to play in Hong Kong," 
said Di, whose portfolio includes both blue-chips and 
small-caps, such as Genscript Biotech Corp  1548.HK . 
     
    PRICING POWER 
    The expected wall of Chinese money heading for Hong Kong, 
fuelled by a need to diversify asset allocation and hedge 
against any yuan depreciation, will also seize more pricing 
power from global investors. 
    "The shift in pricing power will likely occur first in 
small-caps, and then spread to big-caps," said RPower Capital's 
Di. "A single spark can start a prairie fire," he said, 
referencing a civil war slogan of Mao Zedong. "It's the strategy 
of encircling the cities from the rural areas." 
    Hong Hao, chief strategist at BOCOM International, said more 
Chinese participation may actually help reduce volatility in 
Hong Kong, rather than stoke it. 
    "International flows used to dominate Hong Kong, and caused 
a great deal of volatility when they left when times were bad," 
he said. "With the Connect programme, the participants in the 
Hong Kong market should gradually change, giving some much 
needed liquidity." 
    ($1 = 7.7556 HK dollars) 
 
 (Reporting by Samuel Shen and John Ruwitch, with additional 
reporting by Saikat Chatterjee in HONG KONG and Patturaja 
Murugaboopathy in BENGALURU; Editing by Ian Geoghegan) 
 ((samuel.shen@thomsonreuters.com;  +86 21 6104 1789; Reuters 
Messaging: samuel.shen.thomsonreuters.com@reuters.net)) 
 
Keywords: HONGKONG MARKETS/CHINA