ChiNext Valuations Surge as Small Turns Big in China Stocks

Companies in China’s benchmark index for small-capitalization stocks have never been so big.

The ChiNext Index surged 80 percent in the 12 months through yesterday as the median market value of its components jumped to a record $1.1 billion on Jan. 15. That’s the highest ever relative to the nation’s benchmark Shanghai Composite Index, which has a median value of $784 million, and the biggest among small-cap measures in the world’s 10 largest equity markets. Gauges for small companies in Brazil, Russia and India have dropped at least 10 percent during the same period.

President Xi Jinping is seeking to boost the technology and services industries, which comprise about half of the ChiNext’s weighting, and curb the role of state-owned companies as growth in the world’s most-populous nation slows. While UBS AG says ChiNext valuations may fall as a flood of new share sales diverts funds, Bocom International Holdings Co. and Dragon Life Insurance Co. predict a further rally as earnings increase and the government encourages ownership of small companies.

“The ChiNext reflects the part of the economy that has better growth opportunities,” said Richard Gao, a San Francisco-based money manager at Matthews International Capital Management LLC, which oversees about $26 billion. “We are seeing more and more opportunities in the non-state-owned private sector, such as information technology, consumer and health-care industries.”

Funds Buy

The ChiNext index gained 0.9 percent to 1,407.98 at the 11:30 a.m. local-time break, while the Shanghai Composite dropped 0.6 percent.

Money managers in China have increased positions in smaller companies to about 33 percent of holdings, a six-month high, while allocations to large-caps have fallen to 25 percent, according to Hao Hong, chief China strategist at Bocom International, who cited Wind data. The ChiNext may jump as much as 29 percent this year as earnings grow at a 20 percent pace and more funds purchase the shares, Hong said.

“Once you see your peers buying small caps that are outperforming, there is pressure to match up,” he said in a phone interview from Hong Kong. Trading in China’s domestic stock markets is dominated by local institutions, individuals and companies while access for overseas money managers is limited by the Qualified Foreign Institutional Investors program.

Valuation Surge

The ChiNext 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 CSI 300 Index, the benchmark gauge for China’s larger companies with a median value of $3.7 billion, retreated 14 percent in the 12 months through yesterday. The Shanghai Composite dropped 12 percent.

Leshi Internet Information & Technology (Beijing) Co., the biggest company in the ChiNext index with a market value of 37.4 billion yuan ($6.2 billion), has surged 326 percent. The provider of Internet videos and maker of smart TVs is valued at 194 times reported earnings, up from about 45 times a year ago. The company will probably boost earnings by 52 percent in 2014 after last year’s estimated 44 percent increase, according to the average of 10 analysts’ estimates compiled by Bloomberg.

IPO Concern

Huayi Brothers Media Corp., the second-largest ChiNext company, has jumped 283 percent. Huayi’s movie, “Journey to the West: Conquering the Demons,” generated 1.25 billion yuan of revenue last year, the most among domestic films, the China Daily reported Jan. 8. The stock trades at 68 times reported earnings, versus a three-year average of 50 times, data compiled by Bloomberg show.

The surge in valuations is probably unsustainable, according to Chen Li, the chief China equity strategist at UBS in Shanghai. The ChiNext, which slipped 1.4 percent yesterday, trades for 6.1 times net assets. That compares with a multiple of 1.3 for the Shanghai Composite. The Russell 2000 Index, a benchmark gauge of smaller U.S. companies with a median market value of $726 million, trades at about 2.6 times net assets.

A flood of new share sales may weigh on ChiNext companies as investors sell existing holdings to subscribe to China’s first initial public offerings in more than a year, according to Chen, who predicted in May that the “bubble” in small-cap stocks would burst within two months.

Wrist Cutting

The securities regulator has approved 52 companies for IPO sales, according to data compiled by Bloomberg. Companies may raise 250 billion yuan this year, PricewaterhouseCoopers LLP said this month. Neway Valve (Suzhou) Co., the first IPO to begin trading after the regulatory freeze, jumped as much as 44 percent in its debut today.

The increase in supply of shares will “pose a big challenge to the valuation of ChiNext companies,” Chen said at a briefing in Shanghai on Jan. 13.

Government policies are providing support to the stocks. China started allowing insurers to invest in ChiNext companies on Jan. 7, while the Shenzhen exchange said on Dec. 13 that investors must have existing stock holdings before participating in IPOs.

“I don’t see the rally for small caps tapering,” Wu Kan, a money manager at Dragon Life Insurance in Shanghai, which oversees about $3.3 billion.

Premier Li Keqiang has signaled he will tolerate slower growth to shift the economy away from the state-led stimulus that sparked the 2009 recovery, to a more sustainable model based on services and consumer demand.

Tech Support

Transforming the economy is a “self-imposed revolution” that will “feel like cutting one’s own wrist,” Li said at a press conference last March. China’s gross domestic product probably grew 7.6 percent in 2013, the State Council said last month. That would tie 1999’s pace as the lowest since 1990 and be just above the 7.5 percent growth goal for the year. Analysts surveyed by Bloomberg News last month see a 7.4 percent expansion in 2014.

In November, China’s leaders said they would allow markets to play a greater role in allocating resources and encourage private investment in more industries as part of the the biggest expansion of economic freedoms since at least the 1990s. China’s central bank said it supports the development of technology companies and will allow the formation of smaller lenders to support the businesses, according to a statement on the monetary authority’s website Jan. 15.

The ChiNext index has a 29 percent weighting in technology stocks, while health-care companies comprise 21 percent of the gauge and consumer shares account for about 16 percent. Those three groups combined make up about 19 percent of the Shanghai Composite, data compiled by Bloomberg show.

“We are seeing a big change in market capitalization,” said Cao Jin, a fund manager at HSBC Jintrust Fund Management Co. in Shanghai. “This is inevitable given the change in the nation’s economic structure.”

— With assistance by Shidong Zhang, Allen Wan, and Weiyi Lim

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