Hong Kong's small-cap stocks may be in line for a bounce, courtesy of investors across the Chinese border in Shenzhen.
For more than a decade, blue chips have mostly outperformed smaller companies in the former British colony. The benchmark Hang Seng Index of the city's biggest companies climbed about 35 percent between the beginning of 2000 and the end of last week, compared with a 2.6 percent decline for the Hang Seng Composite Small Cap Index, according to data compiled by Bloomberg.
By contrast, small caps have done as well and sometimes better than their larger and more established peers in mainland China, where trading is dominated by individual investors with a greater appetite for riskier and more volatile stocks. The introduction of a trading link between the Hong Kong and Shenzhen exchanges will open more than 100 such companies to mainland investors for the first time, potentially skewing demand toward the market's lower tier.
The Shenzhen-Hong Kong Connect, announced on Aug. 16 and scheduled to be operational in four months, will allow investors to buy Hang Seng Index members as well as all so-called H shares (China-incorporated companies traded in Hong Kong) that also have a listing on a domestic exchange . Unlike an existing trading link with Shanghai, though, the Shenzhen version will also make available all members of the Hang Seng small-cap index that have a market value of HK$5 billion ($645 million) or more. As of Wednesday, 118 stocks met that criterion.
For individual investors with more of a propensity to gamble, small caps offer attractions. Their prices tend to swing more, so there's a better chance of striking a big win than with larger companies that have more limited room to grow.
Punters also need less money to play. Take Li Ka-shing's CK Hutchison, for example. The board lot, or minimum trade size, for the Hang Seng Index member is 500 shares, or HK$49,500 based on Tuesday's closing price. For small-cap index member APT Satellite, the minimum investment would be HK$2,800.
Fundamentals may also favor Hong Kong's smaller companies. The Hang Seng Composite Small-Cap Index is cheap compared with Chinese peers. The index trades at 15 times trailing earnings versus 37 times for the Shenzhen Small Medium Enterprise Composite Index and a multiple of 40 for the ChiNext index of consumer- and technology-oriented companies, according to Goldman Sachs.
Since the Shenzhen Connect is a two-way pipe, there's no guarantee that the link won't be a net drain on Hong Kong stocks rather than a positive. Recent history suggests this is unlikely, though. Outflows from China have exceeded inflows this year through the Shanghai trading link, introduced in November 2014. A weakening yuan has increased the allure of Hong Kong, whose currency is pegged to the dollar. With the yuan down 2.4 percent against the dollar this year, the third-worst performer among emerging-market currencies, that trend looks set to persist.
Blue-chip advocates might argue that Hang Seng Index members are better positioned to benefit. The benchmark gauge trades at less than 12 times reported earnings, even cheaper than the small-cap index, and boasts a dividend yield of 3.6 percent. Big companies are typically more stable, more transparent and more liquid. Earlier this week, Jefferies recommended switching out of the S&P 500 into Hong Kong blue chips, on the back of a wealth of higher dividend-paying stocks that are trading at half the price-to-book ratio of their U.S. cousins.
That's an argument that may appeal to international investors, but China's stock speculators are a more swashbuckling bunch. The biggest gainer out of the 50 members on the Hang Seng Index this year is internet giant Tencent, with a 32 percent jump. The laggard is PC maker Lenovo, which has dropped 34 percent. Compare that range with the small-cap index, where top stock Texhong Textile has jumped 102 percent, while bottom-ranked Universal Health International has shed 87 percent of its value.
Inveterate gamblers always fancy their chances of picking the winners, even when the odds are against them. Small's likely to be looking beautiful from Shenzhen right now.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
The trading link will also open up 673 Shenzhen-listed stocks with a combined market value of $1.9 trillion to investors in Hong Kong.
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