The nature and focus of the Hong Kong stock market are changing ever more rapidly as Hong Kong's July 1 handover to the People's Republic of China draws near.
The Hong Kong Stock Exchange remains heavily weighted toward the property sector. But with the approaching political change, interest has been building in China-play stocks, especially the so-called "red chip" stocks, which are issues of companies incorporated in Hong Kong whose parent is usually a governmental entity in China.
"In the last couple of weeks there have been huge trading volumes on the Hong Kong exchange," said Nigel J. Webber, managing director at Crosby Asset Management Ltd., Hong Kong. "That's partly because the market has gone up, but also because of genuine interest in investing in these China stocks."
The market's performance also illustrates the trend. While in local currency terms, the overall Hang Seng Index this year through June 19 gained 7.8%, the property subcomponent fell 7.5%. But the Hang Seng China-Affiliated Corporations Index, a new red chip index launched this month and backtested to Jan. 1, leaped 66.4%.
Despite their risks, China-related plays have some decided benefits for investors. As more of them become listed in Hong Kong, investors believe they afford more opportunity to partake in the economic growth of China in a way that's safer and more liquid than using mainland Chinese markets.
What's more, the growing number of red chip and H-share stocks (stock of companies domiciled in China but listed in Hong Kong) widen the market's breadth and provide more diversification opportunities. Combined, red chips and H shares now account for nearly 10% of the Hong Kong market's capitalization.
To G. Paul Matthews, president of Matthews International Funds, San Francisco, the new dimensions benefit both investors and the market. For investors, they "broaden opportunities in Hong Kong beyond the traditional (mainstays of) utilities, real estate and banks. This adds breadth to the market and cements Hong Kong's critical role as the financial center for China," Mr. Matthews said.
As data showed, red chip holdings boosted returns of Hong Kong portfolios this year.
Given this sector's strong performance this year vs. the overall Hong Kong market, those who had a heavy exposure to the sector should have significantly outperformed the Hang Seng Index.
But growing interest in red chips isn't the only sign of a "China-ization" of the market. Even some traditional blue-chip companies have felt the need - or pressure - to tighten their links to the mainland. This month's pact involving Hong Kong Telecommunications Ltd. is a recent example. In early June, U.K-based Cable & Wireless P.L.C., agreed to sell a 5.5% stake in Hong Kong Telecom to China Telecom, whose parent is China's Ministry of Posts and Telecommunications. In return, C&W got a minority stake in China Telecom. (According to published reports, C&W is later expected to sell a larger stake in Hong Kong Telecom to China Telecom.)
"Investors who owned Hong Kong Telecom's stock saw it shoot up to HK$19 a share from HK$14 in the space of about a week and a half," recalls Gary Greenberg, deputy managing director, Peregrine Asset Management (HK) in Hong Kong. "They thought Hong Kong Telecom would get better access to China's telecommunications market and would have Chinese assets injected into the company."
The message for investors: that companies with strong or strengthening ties to mainland China could have some business advantages that would pay off in earnings. That message hasn't been lost on institutional investors.
Martin Currie Investment Management Ltd., Edinburgh, has about 50% of its Asian portfolio excluding Japan in Hong Kong, and the firm expects further performance gains. Within that market, "we are looking for companies investing in mainland China. That is the future for (that) stock market," said Tom Walker, head of the Pacific team of Martin Currie. Martin Currie has been favoring red chips, companies with significant Chinese assets or "new companies coming to market that have greater exposure to China.
"For example, we are reasonably positive on the residential market in Hong Kong. But instead of buying the purest residential plays, such as Henderson Land, we have Cheung Kong Holdings, which, mainly through its associate companies has sizable holdings in China and New World Development, which has 30% of its assets in China," he said.
About half of the Hong Kong exposure of the Pacific Tiger Fund of Matthews International Funds is China-related, through red chips and H shares, said Mr. Matthews. The firm is attracted to this segment because of its link to the economic story in China, which is now enjoying low inflation, increased emphasis on reform of state enterprises and continued growth of the private sector. These could add up to a prolonged period of economic growth.
One of Matthews' holdings is Founder (Hong Kong). That red chip is a subsidiary of Beijing University that produces software used for electronic publishing.
In the last several months, the Asia Multi-Strategy Fund L.P., Rockville, Md., bought more red chips and H shares, bringing those shares to 15% of the fund's Hong Kong portfolio, from about 8% at the beginning of the year. Bradford H. Dockser, the fund manager, believes these components give the market a broader reach. "Over time, you'll see a stock exchange and market cap that is more balanced and more representative of the (economy of) the region overall," he said.
In its international equities accounts, Marvin & Palmer Associates, Wilmington, Del., is mostly invested in "traditional Hong Kong listings, such as HSBC Holdings," said Todd Marvin, vice president and portfolio manager. But in the firm's emerging markets accounts, it has a larger exposure to China plays, which include the stocks of Cheung Kong Infrastructure and China Overseas Land.
Mr. Marvin is among those that have noticed the changing character of the Hong Kong market, especially the increased emphasis on red chips. But at this point, following that sector's strong run-up, it has become harder justify investments in it. As Mr. Marvin points out, "some valuations are a concern" with red chips "because things have gotten extremely frothy."
Sandy Nairn, global equity research director for Templeton Worldwide in Edinburgh, is unenthused about red chips. Not only are they speculative but "their prices have been driven up. So, in the short term, we're unlikely to find bargains there," Mr. Nairn said.
The portfolio of global stocks he manages has less than 3% in Chinese stocks, which includes B and H shares. But he owns no red chips in Hong Kong.
He prefers H and B shares (which are listed on mainland China exchanges) because they have been more ignored, he said. To find attractive buys among those companies, investors have to "do more to invest in them," including going to visit the companies themselves.
As for his view on the overall Hong Kong market, Mr. Nairn is "neutral at best." With the market having "gone up a long way . . . we are not finding a huge number" of bargain stocks, he said. "Of the (global equities) portfolio we manage, Hong Kong is about 4% and we're holding it at about that level."