What investors should know when Asian tech names become a bigger part of a major index

New Chinese technology companies are now eligible for the Hang Seng Index, expanding their presence across Asia and likely drawing more inflows from index investors

With offices closed and more working from home, it seems that everyone has become a technology expert. Zoom, Google Hangouts, and Microsoft Team have become part of the new corporate lexicon, where a strong WIFI signal becomes as important as the virtual background one chooses.

As users become technology experts, so do investors.

Along with healthcare companies, technology stocks are leading the recent equity rally. Pre-Covid 19 concerns that an economic slowdown and trade war would derail the consumer upgrading cycle never materialised. As school lessons and work moved online, households upgraded their equipment and adapted to the new normal under the coronavirus.

This matters for index investors, particularly in Asia, where almost a fifth of the MSCI Asia Ex-Japan Index is positioned in information technology stocks. This number can be misleading, as index heavyweights Alibaba and Tencent are classified as consumer discretionary and communication services respectively.

Ignoring other borderline constituents like JD.com, adding Alibaba and Tencent would conservatively lift technology’s exposure to a third of the index which tracks almost 1,200 companies.

Shifting Balance

As Chinese technology companies witness their stock prices climb higher on better trading liquidity, major indexes are taking notice and taking action. This month, the Hang Seng Index (HSI), Hong Kong’s main trading board, will rebalance its constituents for the first time after new rules were introduced to include secondary listed and weighted voting rights companies.

Analysts note that the immediate beneficiaries include e-commerce companies such as Alibaba and Meituan Dianping, as well as smart-phone maker Xiaomi, which together are among the top traded stocks in Hong Kong.

Wong Chi Man, Head of Research at China Galaxy International Securities believes that these three are very likely to be included based on their huge free float-adjusted market cap and trading volumes. Both Meituan Dianping and Alibaba have a three-month average daily turnover above HKD $4 billion, while Xiaomi trades more than HKD $2 billion.

Wong cites Swire Pacific, Sino Land, and CK Infrastructure as possible replacement candidates, based on lower free float-adjusted market cap and thinner trading volumes. All three have a three-month average daily turnover below HKD $200 million. 

The combination of adding new technology stocks and removing other sector exposure adjusts the HSI’s risk profile, laying the groundwork to shift away from property and financial stocks.  Two notable changes emerge:

First, any index that increases its exposure to technology companies indirectly increases its vulnerability to potential political conflict. “Trade tensions between the US and China emanates around technology dominance,” says Eric Ritter, current adjunct professor of economics for Lakeland University in Tokyo, speaking to FinanceAsia.

“Parts of Europe are now turning course with Huawei, while possible US sanctions and limited access to American software clouds the outlook for many Chinese tech companies.”

Second, based on the list of possible candidates that could be removed, on paper the HSI should become less susceptible to sudden changes in interest rates. “The HSI is dominated by financial and property stocks where market values and earnings are heavily influenced by borrowing costs,” explains Ritter. 

But even as more technology names enter the HSI, not all of them will be asset light business models. “Later on, consider 5G related and smart-grid infrastructure stocks, which are companies that expand their balance sheets to take on debt to match project duration.”

Wong agrees. Although the HSI will see a growing internet and technology representation overtime, any meaningful profile changes will occur gradually.

Financial companies account for more than half of the HSI’s sector exposure while property and construction names make up a tenth. Over the next two to three years, Wong expects financial stocks will still account for 40%.

Chasing A Concentrated Performance

At 11% of the HSI, information technology exposure is a single stock, Tencent, which has returned 30% in 2020 compared to the index’s 15% drop. This performance highlights the other challenge as more technology stocks enter the main index: concentration risk.

Although the technology sector is outperforming, the rally is mostly concentrated within a few key names. This trend is occurring globally, leaving index investors vulnerable to the fortunes of a few companies.

In the US, the top 5 stocks as a percentage of the tech focused Nasdaq market cap account for more than 50%, according to estimates by Jefferies. The top 5 stocks as a percentage of the S&P 500 market cap only account for a quarter.

These characteristics appear in China as well. The top 5 stocks on the tech focused STAR Market account for almost half of the total market cap, compared to those on the CSI 300 which make up less than a fifth. Alibaba, Meituan, and Xiaomi together are among the top traded stocks in Hong Kong, with a combined market cap for almost 60% of the HSI.

Globally, technology sentiment appears expensive. The “tech sector, the major component of the Nasdaq’s valuation, has only been higher in the 2000 bubble” says Andrew Slimmon, Head of Applied Equity Advisors Team, Morgan Stanley Investment Management.

On the Shanghai STAR market, the initial 25 companies now trade at more than 130 times their current incomes, almost ten times higher than either Hong Kong or China’s main indexes.

Southbound Driver

But despite the new risk profile, the HSI should benefit in tandem with rising passive inflows from the rebalance. Morgan Stanley estimates that Meituan Dianping, Alibaba, and Xiaomi could draw almost $4 billion of passive inflows.

Any inclusion into the HSI would also qualify companies for the China-Hong Kong stock connect, allowing mainland investors to buy shares in emerging domestic leaders, particularly those with strong commercial branding and are well known in China. 

 

¬ Haymarket Media Limited. All rights reserved.

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