Small is beautiful among China’s equities in 2018 as rally runs out, says country’s best stock picker

Chinese equities with less than 42 billion yuan (US$6.28 billion) in value, known as small-caps, are likely to be back in fashion in 2018, as the country’s market rally runs out of steam, and attention shifts to undervalued equities that had been overlooked, said one of the country’s best stock pickers.

The relative performance of China’s largest equities are approaching “an extreme level” amid a tepid year, where the benchmark Shanghai Composite Index is likely to trade below the current level for most of 2018, said Bocom International Holdings’ chief strategist Hong Hao.

“The rotation from large caps back to small caps will zigzag before the trend becomes apparent for most,” said Hong, who correctly predicted China’s boom-to-bust cycle in 2015. “Large caps, with their steady bond-like earnings but increasingly expensive valuation, have started to lose its appeal, especially relative to bonds.”

Gains on the CSI 300 Index and the SSE 50 Index of mainland-listed large companies have already shown signs of abating, as investors have started to cash out of the stocks on the two measures that have risen at least 20 per cent this year. The two big-cap benchmarks trade at the most expensive level relative to the Shanghai Composite in almost three years on the valuation basis, according to Bloomberg’s data.

Hong isn’t along in being bullish on small-caps. HSBC Jintrust Fund Management’s Qiu Dongrong, another top-performing money manager, said he’s bargain-hunting for growth companies and selling shares of blue-chip companies, as optimism about earnings growth has been factored into stock prices.

The ChiNext index of start-ups has declined 7.7 per cent this year and a gauge of small and medium-sized firms on the Shenzhen exchange remains little changed.

Hong predicts the Shanghai Composite will trade in a range between 2,800 and 3,900 next year, but it will be below the level of 3,300 for more than half of the year. The Shanghai Composite rose 0.1 per cent to 3,321.65 at the end of the morning session on Monday.

The forecast stands in contrast against the bullish outlook by other local brokerages including Founder Securities and China Merchants Securities. China Merchants predicts the Shanghai Composite will rise by as much as 15 per cent next year.

Hong’s prediction of China stocks performance was accurate this year. The Shanghai Composite first closed above 3,300 on August 25, matching his forecast that the index would trade below that level for at least eight months in 2017.

“Given the declining liquidity on the margin, 2018 will once again prove to be a structurally diverging market, and traders will once again have to work within the constraints of limited liquidity,” Hong said. “It is still difficult to see a raging bull market ahead.”