HSNGY Hang Seng Bank Ltd (PK)

HONG KONG—With China set to give global investors greater access to shares listed in the southern boomtown of Shenzhen, some remain wary of a stock market known for its rampant speculation.

A new trading link starting Dec. 5 will give international investors access to more than 800 stocks listed on the $3.3 trillion Shenzhen stock market via Hong Kong's stock exchange. The Shenzhen market, just across the border from the former British colony, is home to some of China's fastest-growing technology companies. It is also rife with speculative trading in small-cap stocks with little institutional research coverage.

The market is drawing interest from investors hunting for undiscovered gems, as some global stock indexes are hitting record highs. It is also forcing investors to do their homework on potential investments in different ways.

William Ma, chief investment officer at wealth manager Noah Holdings (Hong Kong), said fund managers should seek on-the-ground knowledge of a company before buying. "It's difficult to apply traditional metrics to something like tech firms, which have less business visibility. It's hard for management to make projections about earnings when the industry changes so fast," he said.

Fund managers have used creative methods to get such information, including visiting warehouses to see how much inventory has piled up and checking expiration dates on products in supermarkets to see how fast they are being sold, Mr. Ma said.

A few global investors already trade shares in Shenzhen through a quota system, but it is too cumbersome and expensive for many investors to access. As a result, foreign ownership of Shenzhen-listed shares is tiny, just 1.2% early this year, according to HSBC Holdings PLC.

Because foreign funds have had limited access to Shenzhen, few large global investment banks have provided research reports on companies trading there. The vacuum of institutional research, poor disclosure by some listed companies, and a flood of retail traders make Shenzhen one of the world's most volatile stock markets.

Shenzhen's benchmark stock index is down 7.7% this year, while Hong Kong's Hang Seng Index is up 3.7% and the Dow Jones Industrial Average is up 9.9% at a record high.

Trading in many of Shenzhen's small-cap stocks is driven by rumors or speculation. Retail traders call these "demon stocks," when shares mysteriously rise in the absence of news or any change in a company's fundamentals.

Chinese regulators hope the possible influx of foreign institutional investors from the new stock link with Hong Kong, called the Shenzhen-Hong Kong Stock Connect, will help damp volatility in the Shenzhen market and boost transparency.

Yet foreign investors may be wary of buying in now, as Shenzhen stocks are, on average, relatively expensive. Shenzhen's main index trades at 50.4 times expected earnings for next year, while the Nasdaq, to which it is often compared, trades at 28.18 times forward earnings, according to Thomson Reuters data.

As a result, stock pickers are looking at some of the bigger companies in Shenzhen, rather than to richly priced small caps. Many foreign investors and global investment banks suggest buying established companies with proven earnings and strong market positions, including top Chinese brewer Wuliangye Yibin Co. and video-surveillance-equipment maker Hangzhou Hikvision Digital Technology Co.

Still, it is difficult to sort promise from peril.

LeEco Holdings, a tech company that creates online content and sells smartphones and smart TVs, is one example. Acquisitive and attractive to investors, it has showed much promise. But it said recently that it faced a cash crunch after expanding too quickly. Its Shenzhen-listed subsidiary, Leshi Internet Information & Technology Corp., dropped nearly 5% on the news.

Sean Chen, director of strategy at Blackpeak, a firm that has done due-diligence research for those looking to get into the Shenzhen market, said investors often want a better understanding of how management plans to expand a business. They also ask about the background of management teams, their reputation and competency, style and track record, he said.

Anthony Ho, chief investment officer of Asia ex-Japan equities at asset manager Amundi, emphasizes the importance of channel checks—or independent research on a company's business—to verify the accuracy of company information. He said when earnings growth is taken into account, high valuations may be justified.

Dennis Lam, head of Hong Kong and China markets at PineBridge Investments, said, "In Shenzhen, it is even more important to know management. It takes many, many meetings."

He said the firm will also speak to a company's suppliers and factory line managers before investing.

Goldman Sachs Group Inc. recommends investors take a closer look at "new economy" companies trading below 30 times this year's expected earnings. Their list of names to buy in Shenzhen includes Han's Laser Technology Industry Group Co., a laser-machine manufacturer, and Sungrow Power Supply Co., a manufacturer of renewable-energy hardware.

Macquarie recommends Shenzhen Rapoo Technology Co., which boasts stable sales of its wireless-gaming software and is expanding into robotics and drones. Another favorite is GoerTek Inc., which sells a mix of digital consumer products and is expanding into virtual reality.

Write to Anjie Zheng at Anjie.Zheng@wsj.com

(END) Dow Jones Newswires

November 27, 2016 20:55 ET (01:55 GMT)

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