Bhawana Chhabra, CFA, MBA, is a senior market strategist at Rosenberg Research
Hong Kong’s stock market has been overlooked for years on the back of a series of rolling geopolitical and economic uncertainties. With valuations screaming that investors expect a worst-case scenario to materialize, we believe that recent Chinese capital market reforms and a stimulus-driven pickup in near-term growth will spark a turnaround in this forgotten part of the world.
Bumps in the road are to be expected, but patient investors with longer-term time horizons stand to benefit – not only at the headline level, but we also find that the technology and financial sectors offer attractive risk-reward profiles beneath the surface.
The sharp multiple de-rating and price erosion in Hong Kong has been a function of policy uncertainty starting with China’s trade war with the United States in 2018 that accelerated with pro-democracy protests, strict COVID-19 lockdowns, the tech and property sector crackdown in the country, and a still-strained relationship with the U.S. As a result, the Hang Seng Index is still 46 per cent below its early 2018 highs. The broader Hang Seng Composite Index is still 47 per cent off its early 2021 highs.
While there is no disputing that these developments should have weighed on equity prices, a bear market of this magnitude often leaves the backdrop prone to positive surprises. Such investor pessimism means even the smallest of positive catalysts can spark a reversal.
For example, recently announced policy reforms are aimed at re-establishing Hong Kong’s status as a financial hub and boosting liquidity. Easier initial public offerings and offshore listings for mainland Chinese companies in Hong Kong, combined with relaxed standards for exchange-traded funds listed on the Hong Kong, Shanghai and Shenzhen stock exchanges, are the key proposals in the latest round of announcements.
In addition to these reforms, equities have received a boost from Chinese investment flows into Hong Kong facilitated by the Stock Connect program (US$27-billion worth of inflows to Hong Kong in the first four months of 2024, compared with US$40-billion for all of 2023). These flows have been growing steadily as Chinese investors seek to diversify away from a weakening yuan and look for opportunities abroad.
In light of an increasingly de-globalized world, the biggest question facing investors is: Will these reforms be enough to reverse the previous downtrend? What are the downside risks if the reforms don’t come through?
We analyzed the underlying fundamentals for the Hang Seng as well as key sectors comprising the broader Hang Seng Composite (the headline Hang Seng has just three sectors, while the broader Composite has representation from 12, presenting a better picture of underlying dynamics).
• The Hang Seng and the Composite both now trade in the lowest decile of their historical valuations, with roughly a nine times forward price-to-earnings multiple for each. Annualized expected growth in earnings a share for 2022 to 2026 is about 6 per cent for both indexes.
• This compares with 3.8 per cent annualized earnings growth for the Hang Seng from 2013 to 2018 (before the multiple de-rating started to take place) and a forward P/E ratio averaging around 12 times. Current multiples are lower but projected growth is faster. To us, this suggests that the absolute worst is being priced in for the key Hong Kong indexes.
• Having said that, be mindful of blind spots. The top of that list is the property and construction sector, which commands a 5-per-cent to 6-per-cent weighting in both headline indexes. Earnings are expected to decline by 5.5 per cent on an annualized basis over the next four years, especially as the sector remains at the centre of the high-leverage concerns in the Chinese property market. Industrials (2.9 per cent of the Composite) and conglomerates (1.3 per cent) are other sectors with a weak outlook, and overcapacity concerns in China pose headwinds.
• Financials (28 per cent of the Composite) and technology (29 per cent) trade at forward P/E multiples in the lowest quintile, historically, along with PEG ratios (price-to-earnings relative to growth) of 0.8 times and 0.6 times, respectively. This would classify them as great growth picks at reasonable valuations. China’s continued investment in artificial intelligence to fight for global technological dominance and easier exchange regulations (which should mean improved deal flow for banks) are strong tailwinds supporting these two sectors.
Overall, Hong Kong’s equities offer a way to play undervalued Chinese stocks, as markets have priced in a worst-case scenario. Policy reforms will take time, but favourable tailwinds are beginning to emerge. With a favourable risk-reward profile, we recommend broader Hang Seng exposure, or selectively through sectors such as technology and financials, while avoiding property and construction, industrials and conglomerates.
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