(Bloomberg) -- A nascent rally in China’s major state-owned companies may have legs, amid hopes that more official support to revive the sector and plans for higher dividends will help extend the momentum of the country’s hottest stock trade this year. 

A gauge of the largest government-backed stocks has gained 7% so far in 2023, outperforming the benchmark CSI 300 Index by nearly 5 percentage points and staying resilient amid a global banking rout. State firms accounted for half of the top 10 best-performing stocks on the Hang Seng China Enterprises Index, with eye-popping gains including China Satellite Communications Co.’s 118% surge and China Mobile Ltd.’s 49% jump. 

Once seen as a lackluster segment of the world’s second-largest stock market, state-owned firms are drawing a second look from investors after regulators lamented their low valuations. Expectations that SOEs will play an even bigger role in helping Beijing carry out various economic policy initiatives from navigating geopolitical challenges to achieving environmental goals are also boosting optimism.

“The biggest policy surprise this year has been in SOE reforms, and it’s likely to stay a major play,” said Ou Xiao, fund manager at Stone PE in Shanghai. “There are plenty of ways to boost valuations, from incentive plans to asset injections, dividends and stepping up corporate governance.”

China has a sprawling array of state firms, with the central government directly controlling 98 state behemoths that include top banks, mobile operators and energy producers. Investors, though, have at times viewed the sector as inefficient given their mandate to support social policies instead of prioritizing profits.

The renewed optimism in the sector first started late last year when China’s securities chief spoke of a “valuation system with Chinese characteristics” and suggested a new method of pricing companies. The rhetoric gathered pace this month during the National People’s Congress, when a senior securities official called for better funding conditions for SOEs while a regulator proposed a campaign to nurture global champions among them. 

Currently, the CSI Central SOEs 100 Index trades at 10 times earnings as of Thursday, according to the index provider, versus 14 times for the broader CSI 300 Index. By comparison, the HSCEI is trading at 9.8 times earnings.

Still, there are reasons for caution. Worries about recession risks might eventually eat into the safe haven. Historically, rallies in SOE stocks have also remained short-lived due to crowded trades, giving some investors pause. 

“The biggest risk is blindly following the crowd. As SOEs increasingly become the hottest trade, inevitably speculative stocks will emerge and there will be gains that are not supported by fundamentals,” said Hu Juncheng, general manager at Beijing Jiuyang Runquan Capital Management. “Investors will pay dearly for chasing after momentum without independent judgment of a firm’s value.”

But the bulls think this time may be different. Firms are trying to appeal more to investors, including announcing plans to share profits through the form of dividends. Earlier this month, China Telecom Corp., China Mobile Ltd. and China United Network Communications Ltd. announced plans to lift their dividend payout ratios for 2022, sending shares soaring.

Traders also are using the firms as a proxy trade for China’s geopolitical ambitions and policy goals. Shares of domestic state-run oil and construction firms rallied after Beijing helped restore diplomatic ties between Iran and Saudi Arabia, a development that highlights its growing influence in the Middle East.

“When the largest firms are severely undervalued, that just means the situation needs to be rectified,” said Wang Wen, fund manager at China Bowen Capital Management Co.

--With assistance from Mengchen Lu.

©2023 Bloomberg L.P.