As I explained in a recent post (Watch Out: It’s Time for Another Earnings Season!), the third-quarter profit reporting season has so far gotten off to a disappointing start for the S&P 500. Just yesterday, Citigroup announced a 57% slide in profits, joining a growing list of financial shares reporting tens of billions in losses this quarter, thanks to the sub-prime credit crunch that began in July.
In fact, by some estimates profits for the S&P 500 may decline in aggregate for the first time since 2002, with Standard & Poor’s now forecasting a 1% fall in profits from last year’s third quarter.
However the news isn’t all bad this profit reporting season in all corners of the globe. There’s one red-hot market half a world away that’s set to report a 40% surge in profits this year: it’s in Hong Kong!
H-Shares Set to Shoot the Lights Out... Again!
Lately, I have seen a fair share of media commentary about how China is in a “bubble.” It’s gone up far too much already, or so the story goes, and China is way overvalued. Well, yes and no.
You see, there are really two Chinas from an investment perspective. First, there’s the over-hyped, over-priced, and rigged game known as China’s mainland A-share markets. Then there’s the Hong Kong listed H-share market of Chinese mainland stocks.
The A-share market as represented by the Shanghai Composite Index certainly appears to be in “bubble-land” after more than tripling in the past year alone. That’s a run up in price reminiscent of the dot-com era in U.S. tech stocks circa 1999.
But the Hong Kong listed H-share market, while not the bargain it was six months to a year ago, still appears attractive, and is drawing investment money from mainland Chinese investors, as well as global investors, seeking a cheaper way to buy into the booming mainland markets.
Despite Big Gains, Hong Kong is Still a Bargain Compared to China
Increasingly Hong Kong has become a destination exchange for Chinese mainland firms listing their shares to more easily raise capital from global investors. In fact, the market value of Chinese mainland stocks now accounts for 53% of Hong Kong’s total market value, up from just 16% when Great Britain turned over its former colony to China in 1999.
Even after a 40%-plus rally since mid-August, Hong Kong’s main benchmark, the Hang Seng Index, trades at just 19 times earnings, compared to a P/E ratio of about 51 times for the Shanghai Composite – that’s quite a discount in favor of Hong Kong shares.
In fact, according to Bloomberg, “Of the 45 Chinese companies with equities traded both at home and in Hong Kong, the so-called H shares are about 34 percent cheaper than their yuan-denominated A shares.”
Take China Life for example. The leading insurer in mainland China is valued at 74 times earnings in Shanghai, but in Hong Kong, China Life’s H-shares have a P/E of 40.5. In other words, the H-shares would have to rally 82% to close this valuation gap.
Hong Kong Enjoys Growing Cash Flows from Mainland Investors
Earlier this year Beijing began to loosen restrictions on where Chinese citizens could invest their estimated $2.3 trillion in household savings. Recently, the government announced a pilot program that allows retail investors to trade directly in Hong Kong listed shares for the first time.
As a result, JP Morgan estimates $60 billion may flow into Hong Kong in the next year seeking to exploit the cheaper valuations found there. Don’t look now, but it looks like this great wall of Chinese retail money is already finding its way south.
In spite of the major move already this year, Hong Kong can still be considered “undervalued” by some measures. While its P/E ratio of 19 has moved up over the past few years, it’s still far cheaper than Shanghai’s valuation, and in line with the S&P 500’s P/E of 18.
Hong Kong Shares Offer Much Stronger Growth Potential to Boot
Take a look at cash flow and Hong Kong looks like an even bigger bargain, trading at just 5.2 times cash flow, compared with 12 times for the S&P 500 and 11.5 times for the MSCI Asia-Pacific Index, according to Bloomberg.
Profits for H-share companies are forecast to surge 40% higher this year, compared to 22% earnings growth for emerging markets overall. Investing in the S&P 500 by contrast, you’ll be lucky to see profits expand just 7% or so this year. You get what you pay for!
Beijing will have it’s time in the global spotlight during next year’s Olympic games, and Shanghai is still China’s principle trading hub – but Hong Kong is increasingly being viewed as the financial gateway to mainland China – as well as mainland China’s gateway to a wider world of investments.
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