Bubble trouble brewing for shiny China penny stocks

By Clement Tan

HONG KONG, Oct 9 (Reuters) – When it comes to mainland Chinese stocks this year, small is hot.

Up nearly 80 percent in 2013, Shenzhen-listed penny stocks have outperformed a moribund broader market in a big way. But fears are growing that the market is looking ripe for a correction.

Retail investors chasing outsized returns have aggressively pushed small-cap stocks higher, which is much harder to do on large-cap stocks. There are signs that institutional investors are also in the game, prodding penny stocks to record highs.

However, concerns are growing that stock valuations have gone too far ahead of earnings. Investors would also be disappointed if their high expectations of major economic reforms are not met when the ruling Communist Party holds its key policy meeting in November.

The Nasdaq-styled ChiNext Composite Index of mainly high growth, high tech counters listed in Shenzhen and only came into being in 2010, is now trading at 55 times its price-to-earnings (PE) ratio.

This is almost four times the 14.8 times PE ratio that the CSI300 of the biggest Shanghai and Shenzhen A-share listings, which is down about 3 percent on the year. Mid-cap counters have also similarly outperformed.

“It’s definitely a bubble for some of these small-caps, but not true for all of them,” Heather Hsu, CLSA-Fortune Securities A-share strategist, told an investment conference in Hong Kong late last month.

She added that any correction “won’t be major” because private enterprises form the bulk of small caps, which make them more dynamic and more efficient in allocating capital.

But given such strong gains on the year, Hsu said stock picking among listings on Shenzhen’s Growth Enterprise Board will become more important from here on.

Still, such “high and persistent valuation premiums (small-caps have over large-caps) are rare in other world markets,” strategists at influential investment bank China International Capital Corp (CICC) said in a note dated Oct. 2.

Despite the surge this year, the ChiNext board still only has a total market capitalization of nearly 650 billion yuan ($106.19 billion) a far cry from the CSI300’s 14.4 trillion yuan ($2.35 trillion).

CICC expected Chinese penny stocks to lose some of their gains, narrowing the big valuation difference with large-cap counters.
Usually, CICC said, sectors that outperform in the first three quarters of a year underperform in the next three quarters and expensive valuations make this “even more probable.”

Mainland media reported in late-September that block trades in small-cap stocks hit a record high in the third quarter, a sign that that institutional investors have joined the rally.

And there are signs that offshore markets are catching onto this onshore exuberance for smaller, but high-growth counters.

The MSCI China Overseas small-cap index has risen more than 50 percent in 2013, compared to a 2 percent loss for the large-cap dominated MSCI China.

While analysts have generally slashed 2013 earnings expectations after first half reporting season, Credit Suisse analysts warned in a note on Monday that investors should not get too carried away by consensus earnings estimates for Chinese small-caps topping 20 percent for 2014.

China’s small- and micro-cap companies score of 53 on the Analyst Revision Model, a StarMine measure of analyst sentiment. They lag large- and mid-cap peers, which have a score of 60.

StarMine’s Analyst Revision Model ranks stocks based on analysts’ revision of earnings and revenue estimates and changes in their ratings and usually gives additional weight to analysts who have been more accurate in the past.

TOO NARROWLY INVESTED

As small-cap stocks surge, the risks rise for investors who are too narrowly invested in them, as seen when liquor stocks crashed late last year after the incoming party leadership launched an anti-corruption drive.

Policymakers talk of increasing the institutional investor presence. But China’s markets, according to analysts, are still largely driven by retail investors, who tend to pile into stocks with a common investment theme, leading to outsized gains.

The speed with which this cash moves as investors hunt for pockets of growth in an economy that is slowing, has not only added to the volatility. It has also magnified the contrasting fortunes of sectors in or out of favour.

Sector-wise, technology and pharmaceutical counters have outperformed “old economy” sectors such as resources and industrials struggling with chronic overcapacity issues.

But these outperforming sectors – which dominate ChiNext listings – also saw the highest percentage of companies missing earnings expectations in 2012, according to Thomson Reuters StarMine.

Not much has changed so far in 2013 and with third-quarter corporate results due in the next few weeks, any earnings disappointment could trim the outperformance in these fast growth counters.

To be sure, part of the allure of penny stocks has got to do with the size, or the lack of it.

“Thematically, the sectors that dominate the ChiNext shares will form the Chinese economy in future,” said Hong Hao, chief strategist at Bank of Communication International Securities.

But, Hong said, there was a more compelling reason for investing in these stock than hopes of future growth.

“It’s just much easier to make a quicker buck off smaller caps.”
($1 = 6.1211 Chinese yuan)

(Additional reporting by Patturaja Murugaboopathy in BANGALORE; Editing by Simon Cameron-Moore)

This was originally published at Reuters.com.