A contrarian view of Hong Kong

17 June 2020
It’s hard to find a market that’s had a tougher run than Hong Kong lately, but this is exactly where and when value can emerge for astute investors. Fidelity China Special Situations PLC’s Dale Nicholls outlines where he sees opportunities - particularly in unloved small-caps - and discusses two key trends that could signal an inflection point for the market.

 

Key points:

  • Months of protests in Hong Kong have unsettled investors, adding to uncertainty over US-China tensions, Covid-19 lockdowns and a recent spate of attacks by short-sellers.
  • However, we believe a recent uptick in privatisation deals and rising participation by mainland Chinese investors could be potential catalysts for improved performance.
  • With aggregate valuations at historic lows, we see stock picking opportunities for investors willing to look through the uncertainty and take a longer-term view.

Bearish sentiment has brewed into incessant routs for what is the world’s de facto proxy market for investing in China’s growth. On a price-book basis, Hong Kong equities are as cheap as they have been in two decades relative to both the S&P 500 Index and the MSCI World Index. Similarly, if we compare price-earnings (PE), Hong Kong is trading at its 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.

Take privates

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 under-priced 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 US$1.1bn offer for Huadian Fuxin Energy shares and spurring a 60% 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.

Southbound flows

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.
Net inflows to Hong Kong through the Stock Connect program, first launched in 2014, have exceeded HK$300bn this year, compared to HK$222bn in 2019 and less than HK$70bn 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$5bn 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.

Although aggregate valuations look 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 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.
 

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The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments are subject to currency fluctuations. Fidelity China Special Situations PLC can use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. This trust invests more heavily than others in smaller companies, which can carry a higher risk because their share prices may be more volatile than those of larger companies and the securities are often less liquid. This Investment Trust invests in emerging markets which can be more volatile than other more developed markets. The shares in the investment trust are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trust can gain additional exposure to the market, known as gearing, potentially increasing volatility. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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