China’s Riskiest Stocks Proving Safest Bet

China’s riskiest companies are proving the safest bets for stock investors.

The E Fund ChiNext Price Index exchange-traded fund, which tracks the benchmark gauge of the nation’s small-capitalization stocks, has delivered the highest risk-adjusted return among 23 Chinese ETFs during the past four years as a 67 percent gain compensated investors for bearing the highest volatility. The 50 smallest initial public offerings in that period have surged 151 percent on average, versus a loss of 22 percent for the largest deals, according to data compiled by Bloomberg.

Small-cap stocks are outperforming because they dominate the services, technology and health-care industries, among the key parts of China’s $9 trillion economy that policy makers are counting on to drive growth as incomes rise. Larger companies from state-controlled Bank of China Ltd. to Jiangxi Copper Co. have fallen out of favor as Prime Minister Li Keqiang seeks to wean the country off government-led spending that fueled overcapacity and debt levels more than twice the size of economic output.

“Investors prefer smaller stocks that are in sectors with strong structural themes,” Erwin Sanft, the head of China and Hong Kong equity research at Standard Chartered Plc, said by e-mail in Hong Kong on June 16. Smaller companies have “higher volatility so there’s the enticement for higher returns in a short timeframe.”

IPO Wagers

China’s first IPOs in four months show investors are placing big wagers on smaller companies. Shandong Longda Meat Foodstuff Co., Wuxi Xuelang Environmental Technology Co. and Feitian Technologies Co., each valued at less than $510 million based on their IPO prices, were all oversubscribed by at least 120 times in online bidding.

The three stocks all jumped by the maximum 44 percent as they started trading on the Shenzhen Stock Exchange today.

Money managers in China have increased their holdings in smaller companies to 33.3 percent from 31.6 percent at the start of the year, while reducing large-caps to 24 percent from 24.4 percent, according to Hao Hong, the chief China strategist at Bocom International Holdings Co. IPOs of smaller companies are favored by individual investors, who account for 99 percent of trading accounts on the Shenzhen bourse and 80 percent for the Shanghai Stock Exchange, he said.

“Small-cap IPOs serve as a lottery ticket for retail investors,” Hong wrote in an e-mail.

Stock Valuations

Investors in the July 2010 IPO of Leshi Internet Information & Technology (Beijing) Co., a provider of online videos and maker of smart TVs, have gained about 1,100 percent through yesterday. Geron Co., a clothing material-maker, has surged 263 percent since its 241 million yuan ($39 million) trading debut on Jan. 28. Shaanxi Coal Industry Co., the nation’s biggest IPO this year, has gained just 3 percent after selling 4 billion yuan of shares five months ago.

Small-cap shares are vulnerable to declines as investors shift money into IPOs betting on first-day gains. The ChiNext dropped 13 percent from this year’s high on Feb. 17 through yesterday, versus a 5.2 percent retreat in the Shanghai Composite Index.

Ten companies have started the share-listing process since June 10, with an average price-to-earnings ratio of 17.8, according to the China Securities Regulatory Commission. That’s a 69 percent discount versus the ChiNext’s multiple of 55.5, according to data compiled by Bloomberg. The securities watchdog’s chairman said in a May 19 statement that it plans to allow about 100 IPOs from June through the end of the year.

Low Pricing

“New IPO shares will definitely jump in the first couple of days because of low pricing,” said Wang Weijun, a strategist at Zheshang Securities Co. in Shanghai. “But that will come at the cost of existing stocks, particularly small caps.”

Chinese investors are willing to weather volatility in smaller companies for the prospect of outsized returns, Gerry Alfonso, a sales trader at Shenyin & Wanguo Securities Co., said June 16.

The ChiNext climbed 2 percent at the close today, while the Shanghai gauge added 0.65 percent.

E Fund Management Co.’s 1.75 billion yuan ChiNext Price Index ETF returned 2.1 percent on a risk-adjusted basis since June 2010, according to the BLOOMBERG RISKLESS RETURN RANKING. While the fund’s volatility reading of 31 was the highest among peers, a total return five times bigger than the No. 2 fund offset the wider price swings.

The iShares FTSE A50 China Index ETF, which tracks the largest companies traded in China, posted a loss of 26 percent in the period.

No Stories

“Large caps lack volatility and are difficult to move, like big elephants,” Oliver Rui, a professor of finance and accounting at China Europe International Business School in Shanghai, said by phone on June 24. “Large caps represent the traditional parts of the economy that don’t have any stories. They are not exciting.”

China’s state-owned companies, which have benefited from cheap credit and monopoly positions for years, face a less comfortable future after Communist Party leaders pledged in November to give market forces a bigger role in the economy. The central bank said in January it supports the development of technology companies and will allow the formation of smaller lenders to support the businesses.

Investors will keep pouring money into smaller companies as “the growth driver is more favorable,” Kelvin Wong, a Hong Kong-based analyst at Bank Julius Baer & Co., which has about $287 billion under management, said by phone. “There are more catalysts.”

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

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