The stocks have lagged behind the property, banking and H-share index this year Red chips could be the next star performers if the companies scale back their Hong Kong operations to focus more on the flourishing mainland economy. Funds are beginning to look for market laggards as investors rotate out of industrials, property and banking counters, which have made sizeable gains this year on asset price reflation hopes. Since hitting a bottom in April, property and banking stocks have rallied 65 per cent and 34 per cent, respectively. But red chips have trailed behind, gaining just 28.96 per cent since the start of the year, compared with the 74.16 per cent jump in H-share companies, which focus solely on the mainland economy. Analysts blame the corporate structure of red chips for their underperformance. The firms are usually involved in an array of businesses in Hong Kong and the mainland, and some analysts characterise them as a mix of red and blue chips. Because they hold assets in Hong Kong, most of the red chips have not benefited from the strong economic growth in China, and it showed in their first-half earnings. Profits at the companies rose just 23 per cent, largely due to exceptional gains from asset disposals, HSBC Securities analysts Jeannie Cheung and Thomas Yu said. Earnings at H-share companies grew 64 per cent in the first half, thanks to strong commodity prices following robust demand in the mainland. Stripping out the effects of higher commodity prices and the impact of Sars on aviation firms, H-share earnings would have grown only 10 per cent in the first half. Red chips - controlled by mainland interests but registered as Hong Kong firms and listed on the stock exchange - originated as the window companies of mainland municipal cities. They had garnered attention previously after the central government injected state-owned assets into the firms. Some analysts and fund managers say red chips can perform better if they sharpen their focus on their mainland operations. China Everbright assistant general manager Frederick Tsang said red-chip companies could divest of their Hong Kong assets and reinvest the money to boost their exposure to China, whose 7 per cent economic growth is far stronger than Hong Kong's. A closer look at the earnings of H-share companies shows their margins are coming under pressure, calling into question the huge run-up in the sector. 'It would be premature to conclude that H-share earnings quality improved in the first half, and the rerating argument is not too convincing based on the results,' Ms Cheung and Mr Yu said. On the other hand, red-chip companies had shown improving margins, the analysts said. Still, some analysts say H shares remain the better bet for investors wanting exposure to the mainland. While red chips have been talking recently about buying assets in China, strong loan growth on the mainland indicated Chinese companies were in no rush to sell their assets at a discount to their Hong Kong counterparts, First State Investments Greater China equities director Martin Lau said. Also, in addition to their attractiveness on a fundamental basis, H shares will continue to benefit from speculation the central government will soon begin the qualified domestic institutional investment (QDII) scheme. The QDII scheme will allow mainland money to flow across the border and into Hong Kong-listed equities, with H shares seen as the primary beneficiaries because they trade at as much as a 70 per cent discount to their A-share counterparts. While it is generally believed that the QDII plan would not be imminent, it is understood the scheme would be implemented in the longer term as a means to help ease the yuan appreciation pressure by allowing funds to flow out of the country. On the valuation front, H shares are less expensive than red chips and Hong Kong blue chips. The H-share index has a forward price-earnings multiple of 11 times, compared with 13 times for the red-chip index and 17 times for the Hang Seng Index.