Hong Kong small caps are of particular interest to me because I live and work in Hong Kong as a professional investor of retirement portfolios, and am always looking to put together higher quality and better valued portfolios than those available from broad market cap weighted index funds and ETFs. A “small cap” company is one whose outstanding shares of common stock have a total market value of less than than those of “large caps” and “mid caps”. These aren’t always well-defined categories, but in Hong Kong, one could say the “large caps” are components of the city blue chip Hang Seng Index. As of this writing, the smallest component of the Hang Seng Index was Chinese computer maker Lenovo with a market cap of around HK$50 billion (US$6.5 billion), after Cathay Pacific was famously dropped from the index late last year.
One main “edge” I have with Hong Kong small caps is that it is easy enough for me to go meet them, while many larger fund managers won’t bother going to meet them. This can let me find truly interesting companies that are just as interested in a smaller, more specialist fund manager taking the time to come meet them, but ultimately I only take the time to look at and meet these companies when I feel they are actually likely perform substantially better as investments than the broader market. Broadly speaking, Hong Kong small caps have underperformed the Hang Seng index from 2000-2018 as shown in the chart below. I believe the main factors driving this, which disproportionately affect Hong Kong, include:
- Smaller listed companies in HK tend to remain highly controlled by a small group of insiders
- HK small caps tend to fund themselves by continuing to issue more shares, helped by the fact that…
- … these companies historically have traded at much higher long-term valuation multiples
The 2nd chart from my data tool on gfmpartners.com shows that low float companies tend to be net issuers of shares, leaving shareholders with negative buyback yield. So despite charts like this showing the broader underperformance of Hong Kong small caps, I continue to look for opportunities here using valuation and shareholder treatment as two initial screening conditions.