Short seller threat has HK rally skipping small caps

HONG KONG: Hong Kong stocks may be Asia’s star performers this year, but it hasn’t done much to revive the fortunes of the market’s perennial underdogs: small-cap shares.

A peek under the hood of the Hang Seng Index’s 25% surge shows it’s being dominated by larger equities, with smaller companies trading at their biggest price discount to the big caps since 2009. That’s despite expectations a trading link between Hong Kong and Shenzhen set up in December would lure mainland money into the former British colony’s smaller shares.

For Hao Hong, the Bocom International Holdings Co strategist who called China’s boom-and-bust equity cycle in 2015, the lack of appetite for small caps comes down to two things: the economy and short sellers.

There are signs China’s economic momentum is waning, read more here.

“In a slowing environment, big caps tend to outperform,” he said, adding that they’re more liquid, often have higher dividend yields and can be more transparent. “Investors are avoiding small caps due to concerns about short selling - it seems that short sellers are increasingly interested in small caps in Hong Kong.”

Short sellers have taken on at least four Hong Kong-listed companies this year, among them snack maker Dali Foods Group Co and furniture company Man Wah Holdings Ltd, a target of well-known short-seller Carson Block. According to Hong, there were only about two short targets a year in Hong Kong before 2014, when the numbers started to pick up.

Small-cap shares also bore the brunt of a selloff in June, when concern over cross-shareholdings inflating their valuations spurred a cascade of losses in a group of stocks.

“Fears about increased short-selling activities around small caps in Hong Kong are definitely part of the reason for investors avoiding small caps this year,” said Francis Cheung, head of China-Hong Kong strategy at CLSA Ltd.

Conversely, money coming in to the market via exchange-traded funds and support from China’s government-backed funds, known as the ‘national team,’ have fuelled big-cap gains, Cheung said.

But it’s been mainland investors which have propelled the wider Hang Seng’s outperformance this year, as stricter capital controls make the stock connects between Shanghai, Shenzhen and Hong Kong one of the only ways those onshore can get their money into foreign currency.

Net flows in to Hong Kong via the links have come in at more than 240 billion yuan (US$36bil) this year, versus 131 billion yuan for the same period of 2016, when the Shenzhen connect didn’t exist.

While onshore cash is still flocking to Hong Kong, small caps aren’t the attraction. Of the top 10 stocks in which mainland investors hold the highest stakes via the Shanghai and Shenzhen trading links, only two - Guangzhou Baiyunshan Pharmaceutical Holdings Co and China Molybdenum Co Ltd - are members of the Hang Seng small cap gauge.—