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Fetch! The Chinese small-cap stocks to buy in the Year of the Dog

Each week, a professional investor tells us where she’d put her money. This week: Tiffany Hsiao of Matthews Asia selects three Chinese small-cap stocks with exciting potential.

February saw the onset of the Chinese New Year and the Year of the Dog. Investors will be hoping for a repeat of the Year of the Rooster, which saw the MSCI China index rise by nearly 60% in 2017. Despite that, Chinese smaller-companies equities, an area of the market held by few investors, have lagged this return. In 2017, the MSCI Chinese Small Cap index delivered nearly 25%, illustrating starkly the difference in return between large and small caps in China.

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However, small-cap companies in China are at the forefront of the country's economic shift away from fixed-asset investment towards innovation, consumption and services. The amount of innovation taking place in the more entrepreneurial parts of China is breathtaking and smaller Chinese companies are tapping right into it. They tend to thrive mostly in productivity-and value-enhancing industries, such as automation, health care, e-commerce and education. The opportunities for stockpickers are vast: thereare approximately 4,300 companies domiciled in China that have a market capitalisation below $3bn, which we define as small caps.

Riding a wave of innovation, China's smaller businesses are poised to come into their own as investment opportunities in 2018. Last year was undoubtedly the time of Chinese large-cap technology stocks, thanks to the performance of several large internet firms. Many other opportunities may be available this year further down the market-capitalisation scale, however, if investors are willing to look.

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In our view, smaller companies offer prospects for higher growth at lower valuations because they are less well known. This allows active managers to uncover investment opportunities among high-quality companies with good corporate governance at lower valuations.

A world leader in its industry

Silergy (Taiwan: 6415) is China's largest semiconductor firm. We believe it could potentially become the world champion in its sector in the next decade. Semiconductors will be an important structural growth area for China as it tries to become self-sufficient in semiconductor production. Silergy was innovative in creating a virtual integrated device manufacturer (IDM) business model that sets it years ahead of its competitors.

The FedEx of the seas

We also like shipping business SITC International Holdings (Hong Kong: 1308). This company, which unlike many of its peers is not laden with debt, has been described as the FedEx of the seas, allowing Asian companies to move vital goods around the region. It only focuses on smaller ships, to create more frequent trips, and as a result has been able to maintain profitability throughout difficult periods in shipping.

A solid track record

Our third pick is the waste-management firm Sunny Friend Environmental Technology (Taiwan: 8341). This company is strong in both industrial and medical waste, both of which have strong growth in China based on increasing demand. Few Chinese firms have long track records in dealing with such waste processes, which are hard to handle.

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