By Jason Xue and Summer Zhen

SHANGHAI/HONG KONG China's annus horribilis has seen its stock markets fall, funds run up losses and foreign investors run for the exit. But areas of the market dominated by small stocks and frequented by the country's retail investors have done surprisingly well.

Scores of retail investors are dabbling in micro-cap stocks - stocks whose market capitalisation is tiny - operating under the radar of big funds and investors and their massive market-moving flows.

Take self-employed retail trader Joseph Cui, for instance. By buying micro-cap stocks of artificial intelligence(AI) companies, Cui has picked a corner of the market big fund managers can barely squeeze into, and made a fat 20% return on his 2-million-yuan ($273,347.27) investment. "It's a tough environment for big capital. But for short-term money, it's easy play," Cui said.

Strategies such as Cui's stand out this year in a stock market depressed by China's wobbly economy, heightened geopolitical risks and surging overseas interest rates. The Wind Micro Market Cap Index, which tracks the 400 China-listed A-shares with market value typically less than 3 billion yuan each, is up 37% so far this year. In contrast, the blue-chip CSI300 Index has lost 8%. While institution-dominated companies with large market values in sectors such as banking and manufacturing have faced selling pressure from investment funds in a struggling economy, micro stocks have become neat counter-cyclical targets. Such stocks lend themselves to speculation, particularly when tied in some way to Chinese chip behemoth Huawei Technologies or hot concepts such as AI, making the retail rush somewhat similar to last year's meme-stock frenzy in the United States, albeit without short-sellers on the other side of the trades. Chinese regulators meanwhile seem cool with the micro-cap craze, even though it is worryingly reminiscent of the casino-like Chinese market culture of more than a decade ago. "Regulators appear to be greenlighting speculative activities so as to prop up the stock market," said Yuan Yuwei, fund manager at Water Wisdom Asset Management. "The connivance is hurting the system of value investment, encouraging misbehaviours, and is negative to long-term health of the market."

The China Securities Regulatory Commission (CSRC) did not immediately respond to a request for comment.CONCEPT STOCKS Retail investor Helen Wu is not bashful talking about "stir-frying" - the practice of pumping up stocks with hot concepts. "We mainly pick stocks with a big story to tell, such as AI or Huawei, so that stir-frying becomes easy," Wu said, referring to the mania in China around ChatGPT, as well as much-hyped technological breakthroughs at U.S.-blacklisted firm Huawei. "We don't touch stocks with big institutional holdings, due to big selling pressure in a downbeat economy."

Retail investors are a big force in China. CSRC Chairman Yi Huiman notes that their transactions accounted for about 60% of the total A-shares turnover in late 2022. An index tracking China's actively-managed equity funds has slumped 14% this year after sell-offs in once favoured sectors such as battery companies and spirit makers. In contrast, an index tracking ChatGPT concept stocks such as 360 Security Technology and TRS Information Technology has soared more than 40%. In a recent case, loss-making Ningbo Shenglong Automotive Powertrain System Co jumped nearly 250% in three weeks on speculation that is a supplier for Huawei's planned electric vehicle, forcing the company to flag investment risks last week.

Lu Deyong, a retail trader, said he made a 100% profit of 100,000 yuan betting on a Huawei concept stock, Seres Group, whose shares doubled in the past two months even while it booked a loss for the first three quarters of 2023.

"Market buys Seres for the imagination of its future, not its current fundamentals," Lu said. Some brokerages are starting to recommend micro stocks to clients. GF Securities said in an October strategy report that buying micro stocks is part of a new investment paradigm in a stock market suffering from anaemic growth, and global decoupling risks. "Speculation in concept stocks has been active throughout the year, and regulators have their eyes half-closed," said Huang Yan, general manager of Shanghai QiuYang Capital Co. "A crackdown would dampen an already lifeless market."

($1 = 7.3167 Chinese yuan renminbi)

(Reporting by Jason Xue, Samuel Shen in Shanghai, Summer Zhen in Hong Kong; Editing by Vidya Ranganathan and Simon Cameron-Moore)