Relying on low wages is no option for small caps

WEAK fundamentals and poor quality management feature prominently in any assessment of Hong Kong smaller companies or small cap stocks.

This is the view of brokerage Crosby Securities after doing a regional survey of smaller companies. Hong Kong was one of only two places in the survey where smaller companies overall under-performed their blue chip counterparts.

Outside Hong Kong, the two biggest smaller-cap markets in the region are Malaysia and Singapore.

In Malaysia the small-cap sector flourishes on the back of strong retail investor support. Construction and building materials companies have done very well.

Singapore has the best small-cap sector in Asia. Crosby says strong Gross Domestic Product has fuelled, and has been fuelled, by booming manufacturing growth. Many small caps are evolving from low value into high value-added concerns. In particular, electronics and companies in high-end computer technology businesses are growing.

The brokerage says Singapore has a real technology sector and the government is actively promoting technology and research along with development activities.

In Hong Kong, the story is quite different from the Singapore experience. Crosby says there are some very noteworthy exceptions, but overall Hong Kong smaller companies have and will continue to under-perform the main blue-chip stocks. The reason for this is the very low-value nature of the vast majority of small caps in Hong Kong.

What investors in small caps are looking for is the small-cap effect. This comes from investing in quality management with a strong business franchise and a lot of scope for generating reliable cash flow. With sustained earnings per share growth, price earnings multiple expansion follows and the share catapults forward - the small-cap effect.

What investors get in Hong Kong is low-value businesses with low barriers to entry. This brings in increasing competition, declining margins, declining and more volatile earnings followed by poor cash generation. These companies tend to chase volume, to lower unit costs. They need to increase capacity, leading to negative free cash flow along with a build-up of debt. This makes for bad investments.

Hong Kong companies which have relied on low labour costs for their competitive advantage are being squeezed. They are being pushed out of their sectors as mainland Chinese companies and companies in merging markets around the world enter the foray. Crosby argues what needs to happen is for these squeezed Hong Kong companies to go into more value-added manufacturing. This is only possible through investment in research and development. This kind of investment is not happening though. Yet it is happening elsewhere in the region. For instance, in Korea and Taiwan - not covered by the Crosby survey - The Economist estimates companies are about to invest US$30 billion on semi-conductor chip making. Some of this spending is government backed.

In Hong Kong there is no Government support for this kind of development. Another problem here has been the lack of certainty caused by the political handover in 1997, causing short investment horizons.

What needs to happen in Hong Kong is for there to be a careful examination of what makes the territory tick and what will keep it ticking in the next five to 10 years, irrespective of the 1997 handover.