Immediately following Easter this year, we had an additional public holiday here to observe the Ching Ming festival. Also known as "tomb sweeping day", it can be oversimplified as the day of the year Chinese families visit their ancestors' graves with prayers, gifts, and a cleaning up of anything that might have fallen over it over the winter. "Cleaning up" might also describe what happened on the two days following the 5-day weekend when traders returned to the Hong Kong exchange and sent Hong Kong listed shares soaring almost 10% to levels last seen in 2007.
The Hong Kong exchange pointed out on a LinkedIn post that much of this demand was coming from southbound trading on the Hong Kong-Shanghai connect (that is, investors in Mainland China who, since last November, were buying shares listed in Hong Kong without any special quotas or restrictions other than an RMB500,000 or ~US$80,000 minimum account balance).
Source: LinkedIn, HKEX page
This article will discuss how, despite this recent rally, Hong Kong-listed small caps still offer plenty of value and diversification, especially for those who can select individual names. Small caps can especially enhance the risk/return balance of a portfolio's Greater China allocation when combined with dim sum bonds and/or a long/short position of A-shares vs. H-shares.
Hong Kong Small Caps Underperformed Large Caps by 25% over the past year
"Bottom fishing" can be dangerous if misused as a tool for trying to find absolutely cheap stocks, but can be a useful first screen in at least sorting out which sectors are relatively "hot" versus those that are relatively out of favor. Below is a chart comparing the performance of the iShares MSCI Hong Kong Small Cap ETF (NYSEARCA:EWHS) since its inception versus the large cap benchmark iShares MSCI Hong Kong ETF (NYSEARCA:EWH). The correlation between the two has remained around 50%, but the past year was unusual as one where EWH rose 23% while EWHS fell almost 2%.
Source: Google Finance
This divergence was for some reason specific to EWHS and EWH, which are specifically focused on Hong Kong companies, as opposed to other ETFs discussed later in this article which cover Mainland Chinese companies listed in Hong Kong.
Hong Kong and Greater China converging, but more noticeably in large caps than small caps
"Greater China" is a term widely used in Hong Kong to refer to the tightly knit economic and cultural connection made up of:
- Mainland China (officially the "People's Republic of China" or "PRC");
- Hong Kong (officially an "SAR" or "Special Administrative Region" of the PRC since the handover from the UK in 1997);
- Macau (the other, much smaller, SAR next door since the handover from Portugal in 1999); and
Of all the pairs between them, it is the financial connection between the first two (Mainland China and Hong Kong), which has been most tangible to investors so far. Not long ago, the benchmark Hang Seng Index was simply an index of "Hong Kong companies" based in Hong Kong, with most of their business either in Hong Kong or diversified around Asia. Now, the flagship benchmark has mixed in H-share giants like ICBC (OTCPK:IDCBY, the largest bank in the world by assets) and PetroChina (PTR, China's largest oil company with almost half a trillion USD in revenue and assets). There continues to be a "Hang Seng HK 35 Index", similar to the MSCI Hong Kong index tracked by EWH, but I rarely hear it used here.
The Hang Seng Indices remain the most closely followed benchmarks in Hong Kong and for H-Shares, futures contracts on the Hang Seng Index and Hang Seng China Enterprises Index (H-Shares only) are by far the most liquid futures contracts covering Hong Kong listed shares. That said, for US-based investors, the most active ETFs tracking H-Shares track non-Hang Seng Indices, four major examples being:
- iShares MSCI China ETF (NYSEARCA:MCHI)
- iShares MSCI China Small Cap ETF (NYSEARCA:ECNS)
- iShares China Large Cap ETF (NYSEARCA:FXI)
- Guggenheim Small Cap ETF (NYSEARCA:HAO)
Of these, FXI is by far the largest and most liquid, and HAO is larger and more liquid than ECNS as a China Small Cap ETF, but I will use MCHI and ECNS as my China Large and Small Cap ETFs because HAO's holdings are split roughly 50:50 between MCHI's and ECNS's holdings, making the latter two a better split between large and small in my opinion. The next section discusses size and volume in more detail.
It should also be noted that all these "China" ETFs are almost entirely made up of H-shares, with some holdings in mainland listed B-shares and New York listed ADRs. There are also the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF tracking large and small cap A-shares (NYSEARCA:ASHR) and Deutsche X-trackers Harvest CSI 500 China-A Shares Small Cap ETF (NYSEARCA:ASHS), respectively but those remain quite decoupled from Hong Kong listed shares as mentioned in my last article, and small cap A-shares deserve a separate article altogether.
The importance of looking at all these different Hong Kong vs. H-Share ETFs can be seen in one observation from their correlation matrix: HK and H-Share large caps are more correlated with each other than they are with their own respective small caps.
|Correlation Matrix for the 90 Trading Days ending 9 April 2015|
|Correlation Matrix for the 2 years ending 9 April 2015|
Another way of saying or applying this correlation matrix: of all the ETFs here, EWHS stands out as having the lowest average correlation with the others, and so offers the highest potential diversification benefit.
Size and Volume in Large vs. Small Caps
Looking at the above ETFs pair-wise:
- EWH has roughly 500x the assets ($3bn vs. $6mn) and 1,000x the trading volume (millions vs. thousands of shares per day) of EWHS.
- MCHI has roughly 50x the assets ($2bn vs. $40mn) and 50x the trading volume of ECNS.
- FXI has roughly 30x the assets ($7bn vs. $250mn) and 100-200x the trading volume of HAO.
- For comparison, ASHR has roughly 30x the assets ($1.2bn vs. $47mn) and 20x the trading volume of ASHS.
It is not surprising that large caps have more AUM and volume than small caps (after all, even though there are more small cap than large cap companies, large caps are still much bigger), but what should be surprising is how much more pronounced the difference between the Hong Kong and H-Share ETFs. For anyone who bottom fishes on volume rather than price, this would signal EWHS as a rare "stealth" ETF that relatively few investors seem to be paying much attention to. This is not simply because Hong Kong is small and far away from the US: Hong Kong itself does not have a small cap ETF on its own market - the HKEX only lists one small cap ETF tracking the MSCI Asia APEX Small Cap 200 Index (3004.HK).
That said, the relative lack of ETF attention does not mean Hong Kong small caps are completely ignored - as single stocks, both Hong Kong stocks and H-Shares tend to see volume that on average is proportional to their market cap:
Source: WSJ data on Market Cap and 65-day average volume
Sharp-eyed observers may notice that, on average, components of EWH and EWHS do have lower average volumes than MCHI and ECNS components of the same market cap, but this difference is actually more pronounced in the large cap pool than in the more varied small cap pool.
Big factor: Southbound Stock Connect covers most large caps, but relatively few small caps
As mentioned at the beginning of this article, many observers consider southbound trading on the HK-Shanghai stock connect to be a main driving factor in the recent rally of Hong Kong listed shares. This affects the divergence between large caps and small caps in one very important and rarely mentioned way: only 284 HK-listed shares are currently eligible for southbound trading.
|Percentage of Holdings Eligible for Southbound Trading|
It is perhaps not surprising that the short list of eligible shares predominately represents large caps, covering 95-99% of the Hong Kong and H-Share large cap ETF holdings, but only 33-55% of the holdings of the small cap ETFs. Familiarity is another factor: although it may seem more Hong Kong small caps are eligible for southbound trading than even H-share small caps, it is less likely that a mainland-based investor will be familiar with these companies than with a mainland company that is relatively small but still big enough to be listed "overseas" in Hong Kong.
Fundamental Differences between Small Caps and Large Caps
Besides size, Hong Kong listed small caps differ from large caps in several fundamental ways more dramatically than their US counterparts. For comparison, we will be comparing EWH/EWHS and MCHI/ECNS to the iShares Russell 1000 and Russell 2000 ETFs (IWB and IWM, respectively).
- Hong Kong and H-Share large caps are predominately financial, while small caps represent relatively more consumer and other sectors (as detailed in the below table).
- Small H-shares are much cheaper on a book value basis, with a P/B of 3.3 for MCHI vs 2 for ECNS. Hong Kong's small cap discount is similar to that of the US, with EWHS trading at 1x assets vs. 1.3 for EWH, compared with 2.8/2.2 for IWB/IWM.
- EWHS is by far the highest yielding of all the ETFs with a 12-month trailing yield over 5%. This higher dividend comes from a far more diversified base of a 100 stocks with the top 30 weighing 50%. By contrast, 50% of EWH is made up of 6 names, 4 of which are financials.
Here is a detailed table of the weights of the respective ETFs' holdings:
|ETF Holding Weights by Sector||EWH||EWHS||MCHI||ECNS||IWB||IWM|
Note that in the US, the sector weightings of large caps are relatively similar to those of small caps .
As repeated several times, EWH is dominated by financials making up 64%, with consumer discretionary, industrials, and utilities each making up 10%. This will not surprise anyone familiar with the skyscrapers in Hong Kong's central district, which can be considered a "who's who" of financial, property, and conglomerate names serving the region.
Picture of Hong Kong's Central district from Wikimedia Commons. These buildings represent many of the top Hong Kong listed names in a relatively small space (from left to right, after Lippo and Bank of America): Hutchison Whampoa, Bank of China, AIA, Cheung Kong, HSBC and Standard Chartered.
EWHS is far more balanced than EWH, both in terms of number and weighting of holdings, and in representation of different sectors. As mentioned, EWHS holds 100 names, and 30 of them are needed to add up to a weight of 50%, with the top holding only being 4.5% of the ETF (as opposed to EWH, which holds 18.4% in AIA). Compared with EWH, EWHS has 1/3 the exposure to financials, 3x the exposure to consumer discretionaries, and roughly 20x the exposure to information technology (NYSE:IT). The consumer discretionary sector is nothing terribly exciting from a growth standpoint, but provides relatively good diversification and income from household names like Cafe de Coral (basically a local version of McDonald's in Hong Kong) and Esprit (known globally for its casual clothing). It may also be surprising that an ETF with a relatively high exposure to IT is relatively cheap at a time when silicon valley seems to be going through another tech bubble, but this is because the IT names in EWHS are like its top holding VTech, which make relatively commoditized electronics rather than branded, world class, viral social networks like Facebook or Tencent.
H-Shares show a similar difference in sector weightings between large and small caps. As with Hong Kong and the Hang Seng, MCHI is dominated by financials (albeit with "only" a ~40% weighting) which include many of the largest banks in the world: ICBC, China Construction Bank (CCB), and Bank of China. The weighting of large and small IT H-shares seems far more even, but this is actually due to Tencent, which alone is 10% of MCHI as by far the largest and most heavily traded IT company on the HK exchange, and China Mobile making up most of the Telecom sector exposure at 8.7% of the ETF. 50% of MCHI is covered by 9 names, 5 of which are financials. ECNS on the other hand is spread over 400 names, with no name making up over 2% of the ETF and 100 names needed to make up 50%. Many of ECNS's holdings would be far more obscure to many US-based investors who are not focused on China, with names like BYD (the carmaker), Xinyi solar, and Agile property being far less known outside Greater China.
There are three other metrics I believe distinguish large caps from small caps and, in my view, make them relatively more attractive:
- On top of their lower P/B ratios, roughly 90% of the assets of EWHS and ECNS are tangible, as opposed to 79% of MCHI's and 73% of EWH's.
- Interest coverage ratios for the small caps are around 5-15 times those of the average large caps. This is of course largely due to the high representation of financials among large caps, but also because small caps have had relatively little access to credit and have not been able to be as leveraged as large caps so far. This can be viewed as either a sign of stability (lower likelihood of default/bankruptcy), or as a possibility of future upside (if/when these smaller companies to get access to new credit).
- The standard deviation of P/E ratios (and many other valuation / return metrics) across the holdings of the small cap ETFs are higher, meaning there are more opportunities to cherry-pick in small cap space.
|Row Labels||Std.Dev. of P/E Ratio||Average of Interest Coverage||Average of % of Tangible Assets|
While southbound trading might be the primary driver for HK-listed shares reaching 7+ year highs, there still seems to be opportunity for investors in HK-listed small caps that mainland investors either cannot buy yet (because they are not eligible for the connect) or are less familiar with. Of the ETFs tracking HK-listed shares, EWHS has shown the most dramatic lag in performance, the biggest gap in AUM and volume compared with its large cap peer, and cheap enough valuations on both P/B and dividend yield metrics given the relatively well-known companies it holds. While the author believes these small cap ETFs deserve a larger allocation in US-based portfolios than US-based investors currently seem to be allocating to them, investors with direct access to the Hong Kong exchange may find more opportunities sifting through individual small cap names listed here.
The relatively low correlation between EWH and EWHS then poses a two-edged sword: on one hand, it means there are good diversification benefits to holding both, but on the other hand, it also means EWH may be of limited use as a short hedge against a long position of HK-listed small caps. As on the long side with small caps, investors looking for an "alpha" trade that pairs in a short position of large caps may prefer to select a few of the most over-valued large caps as a hedge rather than EWH.
Disclosure: The author is long EWHS, EWH, FXI, HAO, ECNS, MCHI.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author and the author's firm also holds positions in and provides research analysis on Hong Kong-listed companies that may be held by one or more of the US-listed ETFs mentioned in this article.