It’s hard to find a market that’s had a tougher run than Hong Kong has had lately. Months of protests have unsettled investors, adding to ongoing uncertainty over US-China trade tensions, not to mention the Covid-19 lockdowns and a recent spate of attacks by short-sellers on listed companies with alleged accounting problems. But this is exactly where and when value can emerge for astute investors. In fact, we see two trends that could signal an inflection point for the market: a recent uptick in privatisation deals and rising participation by mainland Chinese investors.
Historically low valuations
Bearish sentiment has brewed into incessant routs for what is the world’s de facto proxy market for investing in China’s growth. Hong Kong’s benchmark Hang Seng Index is trading at book value after its price-book (PB) ratio sank to a record 0.9 times earlier this year. On a PB basis, the Hong Kong gauge is looking the cheapest in two decades relative to both the S&P 500 Index and the MSCI World Index. Similarly, if we compare price-earnings (PE) ratios, Hong Kong stocks show the widest discounts in at least 10 years.
Despite widespread pessimism, we believe in mean reversion and efficient markets where values will be more properly priced over time. Neither the coronavirus outbreak nor the widescale street protests will last forever, but when they do come to an end, valuations will have inflected upward, and bargains may be long gone.
While it’s difficult to predict when prices will return to more rational levels, potential catalysts include a growing trend of privatisation, and rising participation by mainland Chinese investors.
A boom of go-private deals bears testament to how undervalued this market has become. Traditionally, privatisation often evoked the stereotype of a local tycoon’s family delisting underpriced property shares in what by most accounts still ranks as the world’s most expensive housing market. However, taking advantage of discounts to net asset values, more and more Chinese state-owned enterprises (SOEs) are jumping on the privatisation bandwagon.
Power giant China Huadian Corp. became the latest SOE to do so, announcing a $1.1 billion offer for Huadian Fuxin Energy shares and spurring a 60 per cent one-day rally on June 2 at the news. At least nine SOEs, including China Oil and Foodstuffs Corp. and Aviation Industry Corp., have revealed plans this year to take Hong Kong units private. Meanwhile, deals continue to flourish among deeply discounted property firms, with Allied Properties HK Ltd. and Wheelock & Co. among those being privatised by controlling shareholders this year.
A steady stream of investment inflows from mainland China is helping to support valuations, as southbound Chinese investors take advantage of Hong Kong’s price discounts compared to mainland-listed shares. Hong Kong shares of the same companies are about 20 per cent cheaper than those listed in Shanghai and Shenzhen, based on a price-gap index for 130 dual-listed Chinese stocks.
Net inflows to Hong Kong through the Stock Connect program, first launched in 2014, have exceeded HK$300 billion this year, compared to HK$222 billion in 2019 and less than HK$70 billion in 2018. We think southbound inflows will continue to grow, as long as Hong Kong discounts remain sizable.
In recent months, Chinese insurers have been leading a Hong Kong shopping spree, targeting shares with high return on equity and dividend yields. China Life Group, for instance, has bought over HK$5 billion of H-shares in China Agricultural Bank since February. As interest rates decline, it makes perfect sense for insurers to seize undervalued and high-yielding equities.
In fact, southbound inflows have helped to make some market segments look expensive, especially in the technology sector favored by mainland investors. New-economy stocks like Meituan Dianping and Ping An Healthcare and Technology have surged to new highs this year following strong southbound purchases. Hong Kong’s long-term allure for mainland investors is currently also getting a boost from the recent drumbeat of Chinese tech companies that are seeking to decamp from US exchanges or to otherwise pursue a secondary listing in Hong Kong. seeking to decamp from US exchanges or to otherwise pursue a secondary listing in Hong Kong.
Although its valuation looks depressed, the large-cap Hang Seng Index has fared much better than Hong Kong’s small-cap stocks, which have borne the brunt of recent selloffs. The Stock Connect and passive investing through ETFs have helped large caps, but small stocks aren’t as lucky. The MSCI Hong Kong Small Cap Index has been a poor laggard among global peers.
On the bright side, historically low valuations mean there is plenty of room for stock picking. Many Hong Kong small caps are trading at single-digit PE ratios, even when their businesses are viable with healthy cashflows.
As much of the world approaches zero or negative interest rates, there aren’t many places to find a rich supply of stocks with stable growth, high dividend yields and low earnings multiples. Given time, as the macro dust settles, global investors should be lured back by companies that continue to create value for shareholders.