Why the dream run in Hong Kong stocks will continue

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An influx of money from mainland China underlies the exuberant rally in Hong Kong stocks as investors exploit the valuation gap with their Shanghai counterparts, but is the uptrend sustainable?

The benchmark Hang Seng Index, which has soared 12 percent over the past two weeks, pierced the psychological important 28,000 threshold for the first time in over seven years on Monday before paring gains on Tuesday. The index dipped 0.6 percent to trade around 27,840 on Tuesday.

Dismissing the pullback as temporary, strategists are optimistic the rally has legs, noting that valuations continue to look attractive vis-a-vis global peers.

The Hang Seng is currently trading at a price-to-earning (PE) ratio of 12.7, well below Japan's Nikkei 225 at 21.3 and India's S&P BSE Sensex at 15.9.

Morgan Stanley's new target for HK stocks: 30,000
Morgan Stanley's new target for HK stocks: 30,000   

Further upside

"Obviously it's a volatile market here; the key thing we're emphasizing is that we're still well below long-run average Hang Seng valuations," Jonathan Garner, chief Asia and emerging market equity strategist at Morgan Stanley told CNBC.

Morgan Stanley on Monday upgraded its 12-month price target for the Hang Seng Index to 30,000 from 26,800. The new target would mark 8 percent upside from current levels.

"That 30,000 target assumes that we get back to 13 times forward PE, which is where the rest of Asia is trading already, so I think it's quite likely," he added.

The bank also raised its target for the Hang Seng China Enterprises Index, which tracks the H-shares index composed of Chinese stocks listed in Hong Kong, to 15,000 from 12,500. The index last traded around the 14,545 level.

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Regulatory boost

Regulatory changes are behind for the recent rush of money into the Hong Kong market. In late March, the China Securities Regulatory Commission granted mainland mutual funds approval to invest in Hong Kong stocks via the Shanghai-Hong Kong connect scheme.

The scheme, launched late last year, allows Hong Kong and mainland investors to invest in each other's markets up to a daily quota.

Previously, domestic mutual funds were only able to invest in overseas markets through the Qualified Domestic Institutional Investor (QDII) program, which requires regulatory approval.

On Monday, a report in Hong Kong's Oriental Daily speculated that the daily quota for Hong Kong stock purchases by mainlanders under the connect scheme will be nearly quadrupled to 40 billion yuan ($ 6.4 billion), Reuters reported.

"We had about $6 billion of mainland money coming into the Hong Kong markets last week, which is unprecedented," said Garner.

Can Hong Kong stocks get any higher?
Can Hong Kong stocks get any higher?   

Foreign investors joining

Stephen Sheung, head of investment strategy at SHK Private, who is also optimistic the rally will endure, says foreign investors are also jumping on the bandwagon.

"It's more than mainland retail investors pumping money from across the border, it's international money too. A lot of money has been coming from Southeast Asia to North Asia," he said.

Sheung recommends waiting for further consolidation in the market before gaining further exposure.

"Technical indicators suggest the market is currently in overbought territory as gains have been very sharp. But there's going to be some consolidation in the market as investors lock in profits. 26,500 would be a point to re-enter the market," he said.

Ultimately, the market will do well because of reasonable valuations.

"You don't have a lot of markets in the world that are still trading below historical averages. You have the Fed tightening coming up, when it does, market trading at more discounted valuations typically outperform," he said.

Sheung's base case is for the Hang Seng Index to hit 28,900 by year-end.

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Choose wisely

One word of caution when it comes to the Hong Kong market, however, is gains have not exactly been broad based.

"You've seen the mainland investors are much more interested in playing the A-H discount names where the H shares are cheaper than the A names. They haven't picked the big global oriented banks or the names that have the pure Hong Kong exposure," Garner said.

"The fundamentals in relation to some of those names aren't that great. You don't have the policy [easing] driver that you're getting for the mainland exposure names. There's a reason to be somewhat cautious," he continued.