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China Small-Cap Bubble Seen Bursting by UBS After 43% Gain

Chen Li, the UBS AG (UBSN) strategist who predicted the tumble in China’s smallest shares two years ago, says the companies are poised to retreat again after valuations rose to the biggest premium over larger stocks since 2010.

The ChiNext index of Shenzhen-listed companies with a median market value of $765 million climbed 43 percent this year through last week, while the CSI 300 Index, which has a median capitalization of $3.5 billion, rose 2.7 percent. The smaller-company gauge traded for 4.6 times net assets versus 1.7 for the CSI index, the widest gap since June 2010, data compiled by Bloomberg show.

Small-cap stocks have surged on speculation President Xi Jinping’s plan to boost the consumer, technology and alternative energy industries will benefit companies from Huayi Brothers Media Corp. (300027) to Leshi Internet Information & Technology Co. (300104) The rally may get derailed by tighter monetary policy, which helped spur the last slump, according to Chen.

“The bubble may burst” within two months, Chen said in a May 9 phone interview. The Shanghai-based strategist predicted in January 2011 that small-cap stocks would drop as much as 20 percent. The ChiNext gauge fell 21 percent in nine months.

Photographer: Andrew Harrer/Bloomberg

Central bank Governor Zhou Xiaochuan said on April 20 that the slowdown in the first quarter is “normal” as the economy sacrifices growth to make structural reforms. Close

Central bank Governor Zhou Xiaochuan said on April 20 that the slowdown in the first... Read More

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Photographer: Andrew Harrer/Bloomberg

Central bank Governor Zhou Xiaochuan said on April 20 that the slowdown in the first quarter is “normal” as the economy sacrifices growth to make structural reforms.

Investors will rotate out of smaller companies and into larger stocks as liquidity tightens, Chen said.

Tightening Liquidity

China’s money-market rates rose on May 9 after three days of declines as the central bank sold bills for the first time since 2011, draining cash from the financial system. Aggregate financing, a broader measure of credit that includes trust loans and stock and bond sales, was 1.75 trillion yuan ($285 billion) in April, compared with a record 2.54 trillion yuan the previous month.

The ChiNext gained 2.8 percent to 1,051.65 at today’s close. The gauge was created in 2009 as an alternative for smaller companies seeking to raise funds and has fewer listing requirements than the two main boards in Shanghai and Shenzhen.

The index rebounded 21 percent in the first three months of the year, a record quarterly gain, as investors speculated its companies will benefit the most from a December pledge by Xi’s government to focus the economy more on domestic demand and reduce its reliance on investment spending. The gauge fell a combined 37 percent in 2011 and 2012.

China’s economic growth slowed to 7.7 percent in the first three months of the year from 7.9 percent a quarter earlier. Central bank Governor Zhou Xiaochuan said on April 20 that the slowdown in the first quarter is “normal” as the economy sacrifices growth to make structural reforms. Economic reports for April showed consumer prices accelerated from the previous month, while industrial output and fixed-asset investment grew slower than economists had estimated.

Bullish Fund

China International Fund Management’s Du Meng is bullish on the technology, media and alternative energy companies that dominate the nation’s small-cap stock indexes, saying they will benefit most from government efforts to boost consumption and to invest in “emerging” industries.

Du, whose China International Emerging Momentum Fund (CHIEMOM) has climbed 41 percent this year for the best performance among 785 China funds, said in an April 23 e-mail that the companies still have higher growth potential than industries that rely on exports and fixed-asset investment.

Of the Shanghai-based fund manager’s top 10 holdings at the end of the first quarter, seven were small caps that trade in Shenzhen, including Apple Inc. supplier GoerTek Inc. (002241), according to the fund’s quarterly portfolio report. GoerTek has jumped 72 percent this year.

Movie Boom

The government is targeting 8 percent of gross domestic product by 2015 for so-called strategic emerging industries including information technology such as cloud computing, Steven Sun, a Hong Kong-based China equity strategist at HSBC Holdings Plc, wrote in a June 2012 report.

Shares of Leshi Internet, a Beijing-based online video company, have more than doubled this year after profit increased 39 percent in the first quarter. The company trades at 61 times estimated profit, data compiled by Bloomberg show. Huayi Brothers, China’s biggest publicly traded filmmaker, has doubled this year after net income jumped 459 percent on the success of movies such as the action-comedy “Journey to the West.” It trades at 43 times estimated profit, 72 percent higher than at the start of the year, the data show.

An official from Leshi declined to comment on the company’s valuation when reached by phone. Three calls made to the office of the board of directors at Huayi Brothers in Beijing went unanswered. The filmmaker didn’t reply to e-mailed questions seeking comment.

Earnings Outlook

Profits for all small-cap companies rose an average of 2.6 percent in the first three months from a year earlier, compared with a 9.1 percent decline last year, according to Shenyin & Wanguo Securities Co.

The larger companies in the CSI 300 reported average profit growth of 9.8 percent in the first quarter, up from a 3.2 percent increase last year, according to data compiled by Bloomberg.

“Earnings growth for small-caps are still relatively low and don’t match current valuations,” Zhao Longlong and Kong Lingfei, analysts at Shenyin & Wanguo, wrote in a May 6 report. “Risks exceed opportunities for some growth stocks that have had sizable gains.”

Selling ‘Avalanche’

Smaller companies will probably report earnings growth of 25 percent for this year, compared with analysts’ consensus estimates of 50 percent, UBS’ Chen said.

His view is shared by Hao Hong, the chief China strategist at Bank of Communications Co., who predicted in a Bloomberg Television interview on Jan. 2 that smaller companies would outperform. He now says ChiNext stocks are a “crowded trade” that may unwind as profit growth slows.

Chinese mutual funds allocated more than 50 percent of their assets to small-cap stocks at the start of the year, compared with 17 percent for larger companies, according to BoCom estimates. Once funds pare their small-stock holdings, others may follow and trigger an “avalanche” of sales, the Hong Kong-based strategist wrote in a May 6 e-mail.

Small caps are “likely the most risky place to put money,” BoCom’s Hong said. “The strong relative performance of ChiNext is unlikely to last.”

To contact the reporter on this story: Zhang Shidong in Shanghai at szhang5@bloomberg.net

To contact the editor responsible for this story: Darren Boey at dboey@bloomberg.net

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