China's underdog market surges

August 15, 2013: 3:24 AM ET
shenzhen
The Shenzhen Composite is one of the best-performing markets in Asia this year.
HONG KONG (CNNMoney)

Weighed down by a slowing economy and worries over structural reforms, China stocks have been left in the dust this year by their international competitors.

The Shanghai Composite, considered to be the mainland's benchmark, is down 5% on the year. Stocks in Hong Kong haven't performed much better.

But there is one index that has bucked the trend. In Southern China, the tiny Shenzhen Composite has spiked 16% since January, and is among the best performers in Asia.

Why the divergence?

While most of the companies traded in Shanghai are large, state-owned enterprises, the Shenzhen market is dominated by small and mid-sized companies.

The Shenzhen stock exchange is also heavy with small firms in the technology industry, which draws investors seeking exposure to companies with very high growth potential.

Michael Liang of Foundation Asset Management in Hong Kong said that Shenzhen's key to success has been to capitalize on the "universal" excitement over tech companies.

In other words, think of Shenzhen as China's Nasdaq.

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Shenzhen's emphasis on smaller firms also compliments Beijing's efforts to reshape the economy and reduce the influence of state-owned enterprises.

Invesco's Paul Chan said that investors are losing interest in China's "old economy," which is dominated by stodgy industrial and financial companies that often receive support from the central government.

Instead, funds are moving into what he calls "the new economy," a grouping characterized by smaller, more nimble firms that are dabbling in tech, media and telecom industries.

At the same time, there are reasons to think the rally might not last. In China, as in the United States, some analysts think the tech boom could stall at any moment.

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Exactly when that will happen is the "billion dollar question," said Chan, who cautioned that some Shenzhen-listed companies are trading at prices that are much too high to be justified.

"This rally is not sustainable," Chan said. "But nobody wants to leave the party early."

A good example of this, Chan said, is that smartphone demand is cooling off, a trend that can be seen in weak sales for Samsung's latest offering, the Galaxy S4.

Liang also thinks that investors will eventually take another look at Shenzhen-listed companies. At that point, if enough stakeholders decide to cash in their winnings and sell off their holdings, he said the market could spiral downward.

But for now, Chan said that investors "have to chase the return, they have no alternative."

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Nasdaq 4,765.38 16.98 0.36%
S&P 500 2,070.65 9.42 0.46%
Treasuries 2.18 -0.03 -1.27%
Data as of 8:27am ET
Company Price Change % Change
Bank of America Corp... 17.62 0.09 0.51%
Apple Inc 111.78 -0.87 -0.77%
General Electric Co 25.62 0.48 1.91%
Intel Corp 36.37 -0.65 -1.76%
Microsoft Corp 47.66 0.14 0.29%
Data as of Dec 19