Penny stocks glitter as bigger peers lose luster

Inexperienced, retail investors favor low-priced shares as the rally continues, reports Bloomberg.

As individual Chinese investors pour back into the world's hottest stock market, they are leaving their fingerprints all over the place. The most telltale sign: The Chinese equivalent of penny stocks, assets that have long held an allure for amateurs, are trouncing the benchmark index.

Shares in China's CSI 300 Index that were quoted below 5 yuan (81 cents) at the end of September have since jumped an average 63 percent. That compares with a 35 percent gain for all index stocks and 11 percent for those priced above 50 yuan.

That outsized rally reflects the growing market impact of inexperienced investors in a country where new stock accounts are opening at the fastest pace since 2007 and individuals comprise about 80 percent of equity trading.

While professional investors measure a stock's worth relative to the company's assets or earnings prospects, it is the price appearing on computer screens that matters most to people like 35-year-old housewife He Mei. As she sees it, the math is simple — low price equals low risk and lots of value.

"Expensive stocks are risky," she said from the southwestern city of Chengdu, the capital of Sichuan province. "Any drops will result in huge losses."

She said she recorded a return of about 60 percent in her 300,000 yuan account since China cut interest rates in late November, versus 37 percent for the CSI 300. She bought her most profitable stocks at prices below 20 yuan and said she will not touch shares above 50 yuan. She declined to provide transaction details to Bloomberg News, saying she is uncomfortable sharing private financial documents.

The advance in low-priced equities, which is unique to China among the world's five biggest markets, ratchets up pressure on the nation's authorities to educate a new class of investors who had until recently avoided stocks in favor of real estate and banks' wealth management products.

It also poses a challenge for institutional investors struggling to keep up with gains in the $5 trillion market and contain risks at the same time.

Chinese equity mutual funds have returned an average 14 percent during the past three months, trailing the CSI 300 by 29 percentage points, while China-focused hedge funds tracked by Evestment gained just 7.9 percent in the fourth quarter, the latest data available, versus the equity index's 44 percent advance.

"Sophisticated investors will generally buy companies, not stocks," said Vincent Chan, the Hong Kong-based head of China research at Credit Suisse Group AG. "But for A-share investors, stocks are just stocks so they buy them when they are still going up."

The biggest winners in the current rally are already turning expensive on traditional valuation metrics.

Lanzhou LS Heavy Equipment Co, a machinery maker that started trading at 1.68 yuan on Oct 8, has since surged more than 12-fold and now has a price-to-earnings ratio of 227, more than 14 times that of the CSI 300.

Aluminum Corp of China Ltd, whose mainland-traded A shares were priced at 3.88 yuan at the end of September, has gained 57 percent even after the company lost money in the year ended Sept 30 and analysts predicted further losses in 2015. The firm's domestic shares are valued at an 89 percent premium to their Hong Kong-listed counterparts.

While stocks priced below the equivalent of $1 in the United States are often associated with tiny companies and market manipulation, in China some of the nation's biggest firms trade below that level. Aluminum Corp of China, also known as Chalco, is the country's largest producer of the metal and has a market value of about $11 billion.

"I'm not sure how long this rally will last," said Zhu Lixu, an analyst at Xiangcai Securities Co in Shanghai, and some Chinese investors "tend to ignore important fundamentals".

The CSI 300 index fell 0.9 percent to 3,513.58 on Tuesday, a third day of declines.

Individuals have been piling back into equities on speculation the government will revive economic growth from near the weakest level since 1990 and improve the efficiency of State-owned companies.

The number of funded stock accounts in China has increased to 54.1 million from a four-year low of 52.4 million in September, while traders opened 2.7 million new accounts in December alone.

Some individual investors, of course, try to be more selective than just focusing on price.

Shawn Gao, a 27-year-old bank manager in Chengdu, looks for shares that will benefit from government policy changes while using volume and momentum data to help guide his decisions. Even he admits, though, that he is sensitive to the absolute price level, staying away from stocks priced above 20 yuan.

What looks cheap to Chinese investors who focus on a stock's price may actually be expensive. Equities in the CSI 300 index trading below 5 yuan are valued at an average 25 times estimated earnings for the next 12 months, versus 13 times for the overall index.

The market impact of individuals who ignore corporate fundamentals is driving away some of the region's institutional investors, who are concerned speculative price moves will hurt performance, said David Gaud, a Hong Kong-based money manager at Edmond de Rothschild Group, which oversees about $158 billion.

"The market would need more institutionals and less leveraging on the retail side," Gaud said. "This is not liquidity which is of good quality at the end of the day."

That is challenging efforts by Chinese authorities to increase the role of professionals in the world's second-largest stock market, even as programs such as the Shanghai-Hong Kong Stock Connect make it easier for arbitragers to take advantage of price differences between the two markets.

The media, which four months ago helped revive public interest in shares with a series of stories advocating equity investment, are encouraging investors to analyze company performance and pay more attention to risks.

"Investors should not focus solely on the change of stock price, but have to understand the market environment, the companies' leadership, profitability and growth potential," the People's Daily said in an editorial this month.

Yuan Shuai, a security guard for Beijing's subway system, illustrated the challenge for authorities as they try to influence investor psychology. The 26-year-old, who visited a GF Securities Co outlet in Xicheng district in Beijing to open a trading account on Dec 31, said he only buys shares trading below 10 yuan.

"I feel cheap stocks are less risky — big drops won't result in huge losses for me," Yuan said. "I don't know too much about investing, but the stocks my friends recommended have been soaring in the past few weeks."