Source: Wall Street Horizon, Citic Securities Research
Authors: Xu Guanghong, Wang Yihan

After the release of the policy combination on September 24, the Hong Kong stock market saw a significant rise, with the mid-small caps outperforming large caps, a relatively rare occurrence in history. Looking back, since 2019, southbound funds have been the main source of incremental funds for mid-small caps. With the continuous increase in southbound funds, the proportion of Chinese institutions holding positions in mid-small caps has reached 42%. Combined with the excess returns of mid-small caps, it can be basically determined that southbound funds are the driving force behind this round of mid-small cap market rally.

In terms of earnings growth, the fundamentals of mid-small caps are closer to the macroeconomic situation in China compared to large caps. While the valuation of mid-small caps has been suppressed in the long term under foreign selling and poor liquidity conditions, in recent years, foreign funds have been continuously flowing out, causing the valuation of large caps priced by foreign funds to gradually approach mid-small caps.

Since 2015, during the bull market only in 2020-2021, mid-small caps have significantly outperformed large caps. The relatively better earnings growth of mid-small caps, deeper valuation levels after previous adjustments, and the historically largest inflow of southbound funds have collectively led to the outperformance of mid-small caps over large caps.

Currently, with the reversal of investor sentiment under the policy combination and the trend of southbound funds flowing into Hong Kong stocks, as well as the significantly advantageous expectations for mid-small cap earnings growth, in line with the historical outperformance of mid-small caps over large caps; although the historical percentile of mid-small cap valuation is currently high, we believe this is related to Chinese institutions gradually gaining pricing power over mid-small caps, leading to a convergence in mid-small cap valuations with the Chinese system.

Taking everything into consideration, with the continued inflow of southbound funds in the future and no significant shift of foreign funds yet, mid-small caps may have greater opportunities compared to large caps. However, considering the lack of liquidity in small caps and performance volatility, mid caps may be a better choice at the moment. From the perspective of valuation and performance matching, industries like mid-cap medical care, real estate construction, utilities, and information technology are more worth paying attention to. Additionally, we have also quantitatively screened out mid-cap stocks that have more opportunities from the perspectives of earnings, valuation, and southbound holdings for investors' reference.

CNI mid-small cap stocks outperformed large cap stocks in this round of rallies, but in the long term, mid-small cap stocks are not the mainstream of the Hong Kong stock market.

On September 24, a package of policies jointly issued by the People's Bank of China, the Hong Kong Monetary Authority, and the China Securities Regulatory Commission, as well as the stance of the Political Bureau two days later, stimulated a strong rally in the Hong Kong stock market.

Since the market bottom on August 5th, the Hang Seng Composite Midcap & Smallcap Index has achieved the highest increase of 42%, exceeding the 37.5% increase of the Hang Seng Composite LargeCap Index, a relatively rare situation since 2015.

Since 2015, up to the high point on October 7, 2024, the Hang Seng LargeCap Index has fallen by a total of 4.7%, while the Small & Mid cap Index has fallen by 29.0%; and in the six bull and bear cycles since 2015, mid-small cap stocks have generally underperformed in bear markets, and only showed significant excess returns during the bull market period of 2020-2021.

Southbound funds are the main continuous incremental source of capital for CNI mid-small cap stocks, and they are the main driver of the mid-small cap market.

In recent years, amid continuous China-US trade friction, foreign capital's risk aversion towards Hong Kong assets has persisted. Compared to early 2019, the proportion of foreign holdings in mid-small cap stocks has decreased by 18 percentage points to 58%, far exceeding the selling of foreign holdings in large cap stocks.

Even against the backdrop of recent temporary return of foreign capital, mid-small cap stocks are still being sold by foreign capital, reflecting a more resolute selling attitude towards mid-small cap stocks compared to large cap stocks. Southbound funds have continued to increase their holdings in Hong Kong stocks during this period, especially in mid-small cap stocks, with their shareholding proportion rising from 7% in early 2019 to the current 21%.

Combining domestic institutional investors in Hong Kong, the overall shareholding proportion of Chinese institutions in mid-small cap stocks has reached 42%. Looking at the cumulative fund flows, since 2019, southbound funds have been the main continuous source of incremental funds for mid-small cap stocks in the Hong Kong market. The correlation between the interval periods of excess returns in mid-small cap stocks and fund flows outside of southbound funds is low. In the bull market of 2020-2021 where mid-small cap stocks significantly outperformed, southbound funds also poured into mid-small cap stocks at the highest historical rate, hence it can be largely determined that southbound funds are the main driver of this round of mid-small cap market.

CNI mid-small cap.index has a stronger correlation with the economic cycle, and the relative performance advantage also leads to excess returns.

Different from large cap with weighty stocks mainly operating outside mainland China and potentially having more refined management to effectively counter economic cycles, the performance growth of mid-small cap stocks aligns more closely with changes in China's macroeconomy.

In terms of performance growth fluctuations, the performance growth of large and middle cap stocks is relatively stable, while the performance growth of small cap stocks fluctuates more, and there have even been historical cases of overall index losses.

During the bull market of 2020-2021, CNI mid-small cap.index recovered faster after the pandemic shock, showing better performance growth relative to large cap. In the following bear market, the better performance growth of mid-small cap.index compared to large cap also led to smaller declines in mid-small cap compared to large cap, reflecting that fundamental factors were one of the reasons for mid-small cap outperforming large cap.

Poor liquidity results in mid-small cap.index being undervalued, and lower valuations provide greater room for growth.

Although mid-small cap stocks have trading volumes exceeding their proportion of free float market cap in the long term, especially the excess proportion of middle cap stocks, the average daily trading volume of individual small cap stocks is only around 20 million HK dollars, while that of middle cap stocks is around 70 million HK dollars, significantly lower than the approximately 0.5 billion HK dollars of large cap.

The inadequate liquidity significantly suppresses the valuation of mid-small cap.index, with the dynamic PE ratio center of mid-small cap.index notably lower than that of large cap. The period of the slow bull market driven by the domestic supply-side reform from 2016 to 2018 resulted in a deviation in the valuation centers of the two.

Previously, the valuation center of mid-small cap.index was always below that of large cap, and coupled with the pandemic shock at the beginning of 2020, the valuation adjustment for mid-small cap.index was deeper. With subsequent liquidity release, the extent of valuation recovery for mid-small cap.index surpassed that of large cap. The resonance of the aforementioned fundamentals and liquidity brought about a significant outperformance of mid-small cap.index at that time.

From the recent fund flow and valuation perspective, the southbound funds may obtain the pricing power of cni mid-small cap.index.

Since 2023, the intensification of Sino-US trade frictions, combined with the lack of confidence in China's economic recovery by foreign investors, have led to a continuous decline in the valuation of large cap stocks with pricing power held by foreign investors. In the upward trend that started in September this year, the valuation of middle cap stocks has surpassed that of large cap stocks, marking the first time since the second half of 2015.

In this round of rally, the sbouthbound funds continued to flow into the overall Hong Kong stocks market, while foreign funds slightly returned to large caps, but overall continued to flow out of cni mid-small cap.index. Despite the middle cap stocks outperforming the large caps in terms of price performance, with valuations even exceeding those of large caps. Additionally, with Chinese institutions holding positions in cni mid-small cap.index exceeding 40%, it can be determined that the southbound funds have gradually gained the pricing power of cni mid-small cap.index. Looking ahead, the valuation of cni mid-small cap.index may align towards the domestic investor system.

Middle cap stocks are expected to continue outperforming, and it is recommended to focus on sectors that still offer good value for money.

As of October 16, the pe of middle cap stocks is 9.5 times, falling below the large cap valuation (9.6 times) in the recent adjustments. Although the current middle cap valuation is still above the historical average, we believe this is related to Chinese institutions gradually gaining control over the pricing power of cni mid-small cap.index. Subsequently, the valuation of cni mid-small cap.index may move closer to the Chinese investor system.

Meanwhile, the EPS growth rate for middle caps in 2025 is expected to reach as high as 16.5% (Bloomberg consensus forecast, the same below), significantly higher than the 6.3% for large caps. Taking everything into consideration, middle cap stocks offer better value for money.

With the current clarity of Chinese policy bottom and greater liquidity support, the southbound funds may continue to pour into the Hong Kong stock market with higher value for money; coupled with frequent short-term international geopolitical conflicts, the middle-small caps holding the pricing power southbound may have better risk mitigation capabilities. Before foreign investors fully shift their focus, mid-small caps may have a greater opportunity compared to large caps. However, due to the insufficient liquidity of small caps and performance fluctuations, middle cap stocks may be a better choice at the moment.

Moreover, the rebound of specific industries in cni mid-small cap.index this round has been very significant. Looking at the alignment of performance and valuation, middle cap industries such as medical care, real estate construction, utilities, and information technology have higher profit growth expectations and lower dynamic valuations compared to large cap industries, making them worth paying attention to.

Additionally, we also use algo methods to screen stocks with high performance growth expectations, lower than the pe levels of the large cap industry, and with a higher proportion of Chinese institutions holding positions, which may perform better in the future for investors' reference.

Editor / jayden