Southbound funds regain pricing power, is there an opportunity for small and mid-cap stocks in Hong Kong?

After the release of the policy package on September 24, Hong Kong stocks experienced a significant surge, with small and mid-cap stocks outperforming the large-cap index, which is a relatively rare occurrence in history. Looking back, since 2019, southbound funds have been the main source of incremental capital for small and mid-cap stocks. With the continuous increase in southbound fund holdings, the proportion of Chinese capital in small and mid-cap stocks has reached 42%. Considering the excess returns of small and mid-cap stocks, it can be basically concluded that southbound funds are the driving force behind the current small and mid-cap market.

From the perspective of earnings growth, the fundamentals of small and mid-cap stocks are more aligned with the macroeconomic situation in China compared to large-cap stocks. Meanwhile, the valuations of small and mid-cap stocks have been long suppressed due to foreign capital sell-offs and poor liquidity. However, in recent years, foreign capital has continued to flow out, and the valuations of large-cap stocks, which are priced by foreign capital, have gradually converged towards those of small and mid-cap stocks.

Since 2015, only during the bull market from 2020 to 2021 did small and mid-cap stocks significantly outperform large-cap stocks. The combination of relatively better earnings growth for small and mid-cap stocks, deeper valuation adjustments in the past, and the historical maximum influx of southbound funds created a resonance that led to the outperformance of small and mid-cap stocks.

Currently, under the influence of the policy package that has reversed investor sentiment, the inflow of southbound funds into Hong Kong stocks, and the clear advantages in earnings growth expectations for small and mid-cap stocks, the background is quite similar to the historical outperformance of small and mid-cap stocks over large-cap stocks. Although the current valuations of small and mid-cap stocks are relatively high historically, we believe this is related to Chinese capital gradually gaining pricing power over small and mid-cap stocks, which may lead to a convergence of valuations towards the Chinese capital system.

In summary, as long as southbound funds continue to flow in and foreign capital has not significantly shifted, small and mid-cap stocks may have greater opportunities compared to large-cap stocks. However, due to the insufficient liquidity and earnings volatility of small-cap stocks, mid-cap stocks may currently be a better choice. From the perspective of valuation and earnings matching, industries such as healthcare, real estate and construction, utilities, and information technology in the mid-cap sector are worth paying more attention to. Additionally, we have quantitatively screened mid-cap stocks that have better opportunities from the perspectives of earnings, valuation, and southbound holdings for investors' reference.

Small and mid-cap stocks in Hong Kong have outperformed large-cap stocks in this round of surge, but in the long run, small and mid-cap stocks are not the mainstream of the Hong Kong market.

On September 24, a package of policies jointly issued by the People's Bank of China, the Monetary Authority, and the Securities Regulatory Commission, along with the statements from the Politburo meeting two days later, stimulated a strong rise in Hong Kong stocks.

Since the market bottom on August 5, the Hang Seng Composite Small and Mid-Cap Index has seen a maximum increase of 42%, surpassing the 37.5% increase of the Hang Seng Composite Large-Cap Index, which is a relatively rare situation since 2015.

Since 2015, as of the peak on October 7, 2024, the Hang Seng Large-Cap Index has declined by 4.7%, while the Small and Mid-Cap Index has dropped by 29.0%. Moreover, in the six bull and bear cycles since 2015, small and mid-cap stocks have generally underperformed in bear markets, with significant excess returns only during the bull market from 2020 to 2021.

Southbound funds are the main continuous incremental source for small and mid-cap stocks in Hong Kong and the primary driving force behind the small and mid-cap market.

In recent years, with the ongoing Sino-U.S. trade friction, foreign capital's risk-averse attitude towards Hong Kong stock assets has persisted. Compared to early 2019, the current proportion of foreign capital holdings in small and mid-cap stocks has decreased by 18 percentage points to 58%, far exceeding the sell-off of foreign capital in large-cap stocksEven against the backdrop of recent foreign capital's phased return, small and mid-cap stocks continue to be sold off by foreign investors, reflecting a more resolute selling attitude towards small and mid-cap stocks compared to large-cap stocks. During this period, southbound funds have continuously increased their holdings in Hong Kong stocks, especially with the proportion of small and mid-cap holdings rising from 7% at the beginning of 2019 to the current 21%.

Combined with domestic institutions in Hong Kong, the overall holding proportion of Chinese capital in small and mid-cap stocks has reached as high as 42%. From the perspective of cumulative capital flow, since 2019, southbound funds have been the main source of continuous incremental capital for small and mid-cap stocks in Hong Kong, and the excess return interval of small and mid-cap stocks has a low correlation with the changes in capital flows outside of southbound funds. During the bull market from 2020 to 2021, when small and mid-cap stocks significantly outperformed, southbound funds also surged into small and mid-cap stocks at the highest historical rate, thus it can be basically concluded that southbound funds are the main driving force behind the current small and mid-cap market.

Small and mid-cap stocks are more strongly correlated with the economic cycle, and their relative performance growth advantage also contributes to excess returns.

Unlike large-cap stocks, which have major business areas outside mainland China and may have more refined management that allows their performance growth to effectively counteract economic cycles, the performance growth of small and mid-cap stocks is more closely aligned with changes in China's macro economy.

In terms of performance growth volatility, the performance growth of large and medium-sized stocks is relatively stable, while small-cap stocks exhibit greater volatility in performance growth, with instances in history where the overall index has experienced losses.

During the bull market from 2020 to 2021, small and mid-cap stocks recovered faster after the pandemic shock, showing better performance growth relative to large-cap stocks. In the subsequent bear market, the better performance growth of small and mid-cap stocks compared to large-cap stocks also resulted in smaller declines for small and mid-cap stocks, indicating that fundamental factors are one of the reasons for the relative outperformance of small and mid-cap stocks over large-cap stocks.

Poor liquidity leads to a discount in small and mid-cap valuations, and lower valuations provide greater potential.

Although small and mid-cap stocks have long had a trading volume that exceeds their market capitalization proportion, especially with mid-cap stocks having a larger excess proportion, the average daily trading volume of small-cap stocks is only about HKD 20 million, while the average daily trading volume of mid-cap stocks is about HKD 70 million, both significantly lower than the approximately HKD 500 million for large-cap stocks.

The lack of liquidity significantly suppresses the valuations of small and mid-cap stocks, with their dynamic price-to-earnings ratio center clearly lower than that of large-cap stocks. The slow bull market driven by domestic supply-side reforms from 2016 to 2018 was a time when the valuation centers of the two diverged.

Previously, the valuation center of small and mid-cap stocks had always been below that of large-cap stocks, and coupled with the pandemic shock at the beginning of 2020, the valuation adjustment for small and mid-cap stocks was deeper. Following the subsequent release of liquidity, the valuation recovery of small and mid-cap stocks also exceeded that of large-cap stocks. Combining the aforementioned fundamentals and liquidity, the resonance of these three dimensions led to the significant outperformance of small and mid-cap stocks at that time.

From recent capital flows and valuations, southbound funds may gain pricing power over small and mid-cap stocks.

Since 2023, with the intensification of Sino-U.S. trade frictions and the lack of confidence from foreign capital in the recovery of the Chinese economy, the valuations of large-cap stocks, which have pricing power, have continuously declined. Moreover, in the rally that began in September this year, the valuations of mid-cap stocks have surpassed those of large-cap stocks for the first time since the second half of 2015In this round of rising, southbound funds continue to flow into Hong Kong stocks overall, with foreign capital slightly returning to the large-cap market, but overall still continuing to flow out of small and mid-cap stocks. Meanwhile, small and mid-cap prices have outperformed the large-cap market, with valuations even exceeding those of large caps. Additionally, the proportion of Chinese capital holdings in small and mid-cap stocks has exceeded 40%. Therefore, it can be inferred that southbound funds have gradually gained pricing power in small and mid-cap stocks, and in the future, the valuations of small and mid-cap stocks may align more closely with those of domestic capital.

Mid-cap stocks are expected to continue outperforming, and it is recommended to pay attention to sectors that still have cost performance.

As of October 16, the PE valuation of mid-cap stocks is 9.5 times, which has fallen below the large-cap valuation (9.6 times) due to recent adjustments. Although the current mid-cap valuation is still above the historical average, we believe this is related to the gradual mastery of pricing power in small and mid-cap stocks by Chinese capital, and future valuations of small and mid-cap stocks may align more closely with those of domestic capital.

The expected EPS growth rate for mid-cap stocks in 2025 is as high as 16.5% (according to Bloomberg consensus), significantly higher than the 6.3% for large-cap stocks. Overall, mid-cap stocks offer better cost performance.

Considering that the current policy bottom in China is already very clear and liquidity has greater support, southbound funds may continue to flow into the Hong Kong stock market with relatively high cost performance. Additionally, with frequent international geopolitical conflicts in the short to medium term, small and mid-cap stocks that hold pricing power may have better risk resilience. Before foreign capital fully shifts, small and mid-cap stocks may have greater opportunities than large caps. However, due to the insufficient liquidity and performance volatility of small caps, mid-cap stocks may currently be a better choice.

Moreover, the rebound of specific industries in small and mid-cap stocks has been quite significant. From the perspective of performance and valuation matching, mid-cap sectors such as healthcare, real estate and construction, utilities, and information technology have higher expected profit growth rates and lower dynamic valuations compared to large-cap industries, making them more worthy of attention.

Additionally, we have also used quantitative methods to screen for stocks with high expected performance growth rates, valuations below those of large-cap industries, and a high proportion of Chinese capital holdings, which may perform better in the future, for investors' reference.

Author of this article: Xu Guanghong, Wang Yihan (S1010522050002), Source: CITIC Securities Research, Original Title: "Hong Kong Stock Strategy | Opportunities in Hong Kong Small and Mid-Cap Stocks"