Cafe de Coral is among the top 10 stocks on the Hong Kong Small Cap Index. Photo: Wikimedia Commons

Investors are loading up on Hong Kong small cap stocks for the first time in years as compelling valuations and earnings growth upside have them hoping the undersized counters can deliver outsized returns.

The MSCI Hong Kong Small Cap Index has jumped 6.4% this year through March 21, outpacing a 3.6% gain in the MSCI World Small Cap Index during the same span. The index is still down 2.7% over the past decade following two double-digit declines in the past three years.

Small caps are often considered to be a cornerstone of modern investment portfolios thanks to Nobel laureate Eugene Fama’s work in demonstrating the segment’s long-term upside. The University of Chicago economist published empirical data showing value stocks outperformed growth ones and that within the value segment, those in the bottom 10% of market capitalization beat the broader market by an average of 0.42% per month from 1990 to 2011.

This trend has held true globally over the past five years as the world small cap index has exceeded the broader global market by 10.6%. Hong Kong tells a different story, however, as its small cap index has underperformed its corresponding broader market by 43.8% during that time.

DBS Vickers said weak fund flows and cautious earnings outlooks were previously to blame for the prolonged slump.

“But this can change in 2017 thanks to improved market sentiment,” DBS Vickers analyst Alexander Lee wrote in a February report. “Hence we believe a basket of quality small caps can outperform the market this year.”

Lee tabbed software company Kingsoft, sportswear apparel maker Li-Ning Company and car dealership operator China ZhengTong Auto Services as names to watch. He said the companies’ low valuations combined with forecasts for earnings recoveries created a compelling risk-reward opportunity for investors over the next three years.

All three stocks have racked up gains so far this year. China ZhengTong has more than doubled to HK$4.63 (59 US cents) through March 22 despite reporting that basic earnings per share dropped 20.4% last year to 22.3 fen. Meanwhile, Kingsoft has jumped 31.1% and Li-Ning is up 4.3%.

The wide gap between small caps and the broader market over the past several years has led to compelling valuation levels. The Hong Kong small cap index traded at just 13.8 times forward earnings at the end of February versus 15.7 times in the broader market and 16.6 times in the MSCI World Index.

Mainland investors in particular may relish the chance to pick up familiar small cap names at a more reasonable price than what they can find at home. The Shenzhen Stock Exchange, home to many of China’s promising hi-tech, manufacturing and retail companies, traded at an average 27 times earnings on its main board and 71 times earnings on its start-up board known as ChiNext, according to data on March 22.

A higher appetite for risk is another factor that may steer mainland investors toward Hong Kong small caps, said Louis Tse, a director of VC Brokerage.

“For those retail investors, they have gambling in their blood,” Tse said. “They don’t want to go to large caps because they think, why should they pay so much for those stocks [when] it won’t get them big enough returns.”

Net buying from across the border via the Shanghai and Shenzhen Connect southbound jumped 89.9% in February from the previous month to a combined HK$36.6 billion. The trading link is becoming a significant driver in the Hong Kong market, accounting for 6.8% of total main board trading turnover in January and 8.7% in February.

Tse said that Hong Kong and overseas fund managers recognize the upside in select small cap stocks, but would remain cautious on the segment given the amount of due diligence needed to understand each company’s fundamentals.nighttime

“There are a lot of traps within these financial reports that are produced by some of these small cap companies,” he said. “If fund managers put their client’s money on blue chips or balancing strategies, that will enable them to sleep better during the nighttime.”

The Hong Kong small-cap index includes 87 companies with an average market capitalization of US$574 million. About one-third of the index is weighted toward the consumer discretionary sector, with names like Esprit Holdings, Television Broadcasts and Cafe de Coral among the top 10 constituents.

Financial and real estate sectors account for almost a combined 30% of the index versus around a 60% weighting in the broader market.