Shenzhen link offers reprieve to Hong Kong's unloved small caps

[HONG KONG] Hong Kong's small-cap stocks may be about to shake off their underdog status.

The companies will outperform larger peers on their inclusion in the newly-approved exchange link with Shenzhen, according to Erwin Sanft, head of China strategy at Macquarie Group Ltd. The Hang Seng Composite Small Cap Index has declined 6.6 per cent this year and dropped to its lowest level versus a gauge of the biggest companies in seven years on Aug 10.

"Once they start going up they tend to have quite good momentum," said Hong Kong-based Mr Sanft. "When people look at small caps, they find their valuations quite attractive. Small caps should outperform from now on."

The stocks climbed in the days leading up to Tuesday's announcement, when regulators unveiled details on the long-awaited exchange link that's expected to start in about four months.

Eligible equities include Hong Kong small-caps with a market value of more than HK$5 billion (S$864 million). Mainland investors, who've piled 200 billion yuan (S$40.4 billion) into large and mid-cap shares through the existing tie-up with Shanghai, have a track record of favouring more volatile smaller shares at home.

The Hang Seng Composite Small Cap Index, like other gauges in Hong Kong and the mainland, is yet to recover from last year's summer rout. The gauge had surged 38 per cent in just two months through its June bubble peak, while larger companies climbed only 12 per cent.

And it's still down by about a third since Dec 6, 2010, when its relative performance against large caps peaked, data compiled by Bloomberg show.

"Small caps may play catch up but it's difficult to pick the winners," said Daniel So, strategist at CMB International Securities Ltd in Hong Kong.

"I expect more small cap inflows from domestic investors before the official launch. Mainland investors may have other ways to buy Hong Kong small cap stocks before the connect."

Chinese investors have used more than 80 per cent of their quota for buying Hong Kong shares through the Shanghai link, which started in November 2014.

The aggregate investment limits will be scrapped for Shanghai and will not be imposed for the Shenzhen program, while daily caps on purchases will remain, officials said this week.

Compared with the mainland, Hong Kong small caps look like a bargain. They trade at a average projected 12-months earnings multiple of 13, according to data compiled by Bloomberg. That's less than large cap index's 14.3 times and 55 times for the Shenzhen Composite Index.

While a few specific small cap stocks may surge, it's unlikely to be a wide-spread rally, according to Alex Wong, who helps oversee about US$100 million at Ample Capital Ltd in Hong Kong.

Mainland investors will prefer investing in quality blue chips rather than speculative small companies, because they're looking for relatively stable assets that help them diversify out of the yuan, he said.

Some of the biggest gainers over the past week include GCL New Energy Holdings Ltd, Differ Group Holding Co and Tsui Wah Holdings Ltd, jumping at least 23 per cent. Investors may be purchasing companies with a market cap of less than HK$5 billion on speculation their value will swell past the threshold to be included in the link, according to Macquarie's Mr Sanft and CMB International's Mr So.

"There will be some relative performance catch up," said Tony Chu, a Hong Kong-based money manager at Sophus Capital.

"There will be some degree of profit taking and then gradually in the medium to longer term it should benefit the small to mid caps."

BLOOMBERG