Hong Kong's death has been exaggerated
Hong Kong's death has been exaggerated
Estimated reading time: 29 minutes
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Summary
Investor sentiment in Hong Kong is worse than it’s been for over a decade. There’s a perception that the city is changing － or perhaps even dying.
I think that view is probably misplaced. Hong Kong of tomorrow will certainly look more like a typical Chinese city than it used to be. But it retains several advantages, including low tax rates, a currency with an open capital account, and infrastructure more efficient than any other major city.
While the Chinese economy is suffering from the pains of an implosion in construction activity, Hong Kong’s economy is actually fine. Tourists have returned, and retail sales are on a path to recovery. Hong Kong is now enjoying positive net migration. High interest rates weigh on the economy, but those rates could drop from mid-2024 if you believe in the latest Fed Dot Plot.
I reviewed the list of Hong Kong-listed companies with market caps above US$50 million and identified ten stocks that trade at low valuation multiples.
If you’ve followed market prices, you will have noticed that Hong Kong’s Hang Seng index is now back to its October 2022 lows:
What investors are asking themselves right now is whether there might be any diamonds in the rough in Hong Kong. Whether there are any stocks with solid fundamentals that just happen to have been sold down in this ongoing bear market.
In this post, I’ll discuss the case for Hong Kong's equities: why the market has crashed, what investors are concerned about, what could potentially cause them to change their views, and the risks I’m seeing ahead of us. Towards the end, I’ll also discuss ten stocks that trade at low valuation multiples despite solid fundamentals.
Table of contents
1. The opportunity set
2. Timeline of the current bear market
3. Hong Kong remains the centre of Asia
4. Hong Kong’s economy is recovering
5. Potential risks for Hong Kong
6. Hong Kong domestic small caps remain cheap
7. Ten highlighted stocks
8. Conclusion1. The opportunity set
China has the deepest, most liquid capital markets in the Asia-Pacific. You can broadly divide the market into so-called “A- or B-shares” listed on mainland Chinese exchanges such as Shanghai and Shenzhen, American Depositary Receipts (ADRs) of Chinese companies listed in the United States and Chinese companies listed in Hong Kong. For a broad overview of these markets, check out the introduction to Asia-Pacific markets I wrote back in 2022.
Foreigners have the following options when it comes to Chinese equities:
You can buy mainland-listed A-shares through the HK Connect program. These shares can be purchased through platforms such as Interactive Brokers, but are limited to the stocks listed here.
You can also buy so-called B-shares, traded on the Shanghai or Shenzhen stock exchanges but denominated in foreign currencies. Only a few B-shares are listed. Those tend to be sleepy companies with little analyst coverage.
You can buy American Depositary Receipts (ADR), the corporate structure used by most Chinese companies listed in the United States. I wrote about that market here.
Finally, you can buy equities in Hong Kong. The majority of the companies listed here are from mainland China, and those are referred to as Red Chips or H-shares. It’s a massively large market, with an aggregate market cap of almost US$7 trillion.
Mainland-listed Chinese equities (A-shares) have typically traded at a premium to their Hong Kong counterparts (H-shares). But this so-called “A-share premium” has reached its highest level ever at 57%. In other words, Chinese-listed equities in Hong Kong are far cheaper than on the mainland.
This disparity between mainland-listed shares and Hong Kong-listed shares has remained for decades. I don’t think it will change. The most likely culprit is excess liquidity within mainland China, which has a closed capital account. Due to the scarcity of assets, Chinese capital has no option but to invest in overpriced equities. Investors in Hong Kong stocks have more options available to them. It’s also possible that if the Renminbi were measured at market exchange rates, A-shares would actually be valued similarly to their Hong Kong counterparts. I wrote about this theme here in 2021.
Foreigners can also buy Chinese equities listed in the United States. Most of the listings are of depositary receipts representing underlying shares in the Cayman Islands or elsewhere. The problem with these stocks is twofold.
One is that a US SEC agency called the PCAOB has required full access to Chinese audit papers or else, Chinese ADRs might face delistings. If a company is large enough, it can relist in Hong Kong and change its primary listing to there. But investors also face the risk of take-private transactions below intrinsic value. I wrote about that theme here.
Variable-interest entities have never been fully tested in Chinese courts. They operate in a legal grey zone and don’t provide as much protection as owning actual shares.
For these reasons, I think you could well argue that Hong Kong equities offer the best opportunities for savvy stock pickers. They’re cheaper than A-shares and usually represent direct ownership of underlying companies.
So, in this post, I’ll discuss the current opportunity set in Hong Kong as I see it.
2. Timeline of the current bear market
The current bear market for Hong Kong stocks began in 2018. The Hang Seng index peaked on 26 January 2018 around the 33,000 level. Around that time, the Trump administration in the United States reacted against perceived unfair trading practices of the People’s Republic of China, including property theft and forced technology transfers.
For those reasons, the Trump administration raised tariffs on US$50 billion worth of Chinese goods in June 2018. This marked the start of a series of escalations which ended in October 2018 with weighted average trade tariffs on both sides of about 20%:
In the initial stage, Chinese manufacturing companies were hardest hit. Meanwhile, tech companies such as Alibaba and Tencent continued to be favored by overseas investors.
In mid-2019, anti-government protests broke out in Hong Kong. Citizens protested against a proposed National Security Law that would take away the independence of Hong Kong’s judiciary. From this point onwards through COVID-19, tourism in Hong Kong ground to a halt.
The next stage in the current bear market for Hong Kong stocks was Trump’s Executive Order 13959, which I wrote about here. This executive order prohibited US investors from investing in listed Chinese military-linked companies. Stock prices of state-owned enterprises, such as China’s telecom operators, fell precipitously.
COVID-19 led to a shift in investor sentiment. Old-world companies were discarded, while tech companies benefitted from a trend towards people working from home. A speculative frenzy erupted in Chinese tech companies such as Meituan and Tencent.
This speculative frenzy happened just as General Secretary Xi Jinping began a crackdown on China’s largest tech platforms. I wrote about that theme here. While initially seen as a response to Alibaba’s Jack Ma criticizing the government in a famous speech, it soon became clear that the crackdown was not limited to Alibaba. No major tech platform was safe. In the subsequent years, around a dozen major tech CEOs resigned, willingly or not. Companies like Tencent and Alibaba contributed CNY 50 billion each to help further the government’s cause of “common prosperity”. Bytedance and others donated so-called “golden shares” to government entities, and those entities gained board representation. Chinese tech stocks began a three-year bear market.
In July 2021, the Chinese government banned for-profit tuition companies, which were officially aimed at reducing academic pressure on students. The stock prices of companies such as New Oriental and TAL Education dropped like stones.
Around the same time, the government implemented a new policy in the property market called the “Three Red Lines”, which forced China’s overleveraged private property developers to deleverage. They were essentially cut off from all funding sources, and their offshore bond prices now signal bankruptcy across the board. The destruction of wealth was massive: private developers Evergrande and Country Garden alone had debts of over US$500 billion. I wrote about that theme here.
Since then, China’s construction problem has essentially been dealt with. At the peak, residential new starts reached almost 25 million apartments per year, compared to aggregate contract sales of no more than 11 million. This meant a gradual build-up of inventory that the government found difficult to deal with. Now that China’s private property developers have been cut off from credit, construction has been curbed. Residential new starts are down 60%. And contract sales have also dropped as new homebuyers are hesitant to put in deposits on buildings that may or may not be completed.
After Xi Jinping gained a third term at the Party Congress in October 2022, it seems Chinese citizens have lost faith in the economy. There is anecdotal evidence of a shortage of money in local governments, which previously relied on land sales for revenues. Many young people have resorted to simpler lifestyles, a trend known as lying flat. This despondency was beautifully captured in analyst Dan Wang’s 2023 letter, available here.
I’ve lived through a few cycles in the Chinese economy. In 2013, investor sentiment in the A-share was similarly weak. What saved the market then was retail speculation and an acceleration in credit growth from late 2014 onwards.
The problem today is that property construction used to represent 29% of GDP, according to Professor Kenneth Rogoff. That’s no longer the case. The implosion in residential new starts has naturally hurt employment and consumer confidence. The state could theoretically make up for this shortfall in spending, but credit growth remains weak, with the November 2023 print in the single digits.
Part of the problem is that the link between credit and spending might have been broken. Before Xi Jinping became General Secretary of the Communist Party, most lending was to private borrowers, according to Nicholas Lardy.
While the data series was discontinued in 2016, there’s every reason to think that most lending is now to China’s state-owned enterprises. In other words, there’s a lack of credit in the private sector.
I’m not sure what’s going to change the calculus. But the tools are at Xi’s disposal. And I remember how gloomy the outlook was during the Great Financial Crisis in 2008 and the Eurozone crisis in 2012. The solution will only seem obvious with the benefit of hindsight.
3. Hong Kong remains the centre of Asia
The National Security Law in June 2020 was indeed a watershed moment for Hong Kong’s judiciary. Now that individuals seen to be endangering national security can be extradited to mainland China, there’s a fear that they will no longer receive fair trials.
But let’s look at the positive side of things. In reality, the National Security Law has really just had two major effects. One is emigration, and the other is stopping public demonstrations.
Since 2020, roughly 400,000 people have left Hong Kong, according to this data from the Hong Kong Immigration Department. But, if you calculate the cumulative number, net migration has actually started to decrease:
In other words, people are now moving back to Hong Kong. These could be individuals who avoided Hong Kong during COVID-19 and are now willing to return. They could also be people who changed their minds about living overseas, knowing that Hong Kong is a great place to make money. In the early 1990s emigration wave, many of those who left for Vancouver or elsewhere ultimately came back to Hong Kong.
While it’s certainly negative that hundreds of thousands of people have left Hong Kong, it’s not implausible that mainland Chinese immigration could make up for the shortfall. In fact, Hong Kong’s residential rents rose 8.1% in 2023 due to immigration from the mainland.
For now, the Hong Kong legal system remains reliable. The conviction rate for Magistrate’s courts in Hong Kong was 54% last year, far higher than mainland China’s 99.95%. This seems to suggest that Hong Kong judges are still independent. Hong Kong still ranks #23 in WJP’s Rule of Law Index, ahead of the United States.
Between Hong Kong and Singapore, the former remains a far larger financial hub. The aggregate market cap of Hong Kong-listed companies is 10x that of Singapore. Its assets under management are US$2.2 trillion - far higher than Singapore’s US$1.5 trillion. There are 2,000 licensed asset managers in Hong Kong vs just 1,200 in Singapore.
A key competitive advantage for Hong Kong is that its currency is freely convertible and pegged to the US Dollar. This enables the Chinese government and its companies to raise overseas capital while maintaining capital controls within mainland China.
It’s also the case that Hong Kong’s taxes are uniquely low:
The highest marginal income tax is 17%.
There is no capital gains tax.
There is no withholding tax on dividends or interest income.
There is no GST.
There is no estate duty.
There is no wealth tax.
There is a 15% tax rate on rental income but with a standard deduction of 20%.
Most import duties to Hong Kong are zero, making imported goods cheap.
The stamp duty for purchasing residential property is 15% for foreigners and 7.5% for locals, but this stamp duty could soon be removed.
For these reasons, the PwC and the World Bank recently ranked Hong Kong as the region with the most friendly tax system in the world.
The Hong Kong government remains committed to its low-tax policy. Hong Kong has agreed to implement a minimum corporate tax rate of 15% from 2025, but so has many other major economies. The budget deficit is projected to continue at over HK$100 billion in FY2025, but 3% of GDP remains modest.
While I don’t want to minimize the political shift that has taken place, for Hong Kong companies, it will be mostly business as usual. Hong Kong will continue to attract the ultra-wealthy through its low taxes, and it will continue to be used to raise capital for companies in China and beyond.
4. Hong Kong’s economy is recovering
After Hong Kong’s zero-COVID policy was lifted at the end of 2022, the economy has actually been on a solid footing. Hong Kong’s retail sales grew +16% year-on-year in 2023, though remaining almost 20% below the peak in early 2019:
A major component in Hong Kong retail sales comes from tourism to Hong Kong, which is now back to around 70% of the pre-COVID level:
But don’t expect a full recovery in tourism spending. Before 2019, a large portion of Hong Kong retail sales to tourists comprised goods smuggled into mainland China. In 2021, China’s border controls tightened up significantly, and most of such business now occurs through legitimate channels. I wrote about such smuggling here.
One business that is booming is Hong Kong life insurance products sold to mainland Chinese visitors. Related premiums already exceed the pre-COVID-19 level, suggesting strong demand for USD-linked policies.
The Hong Kong private sector PMI has been around the 50 mark over the past few months and 51 in December, suggesting an expansion in private sector economic activity.
Hong Kong’s real GDP grew +4.3% in the fourth quarter of 2023. Hong Kong’s export growth has now turned positive at +11% year-on-year. The unemployment rate remains just 2.9%, suggesting that jobs are plentiful. Commentary from the Hong Kong government:
“The Hong Kong economy continued to revive in the fourth quarter of 2023, with inbound tourism and private consumption remaining the key drivers. According to the advance estimates, real GDP grew by 4.3% in the fourth quarter of 2023 over a year earlier…”
“Looking ahead, the difficult external environment will continue to pose pressures on Hong Kong’s exports of goods in 2024. The situation may stabilise later in the year if advanced economies cut interest rates as expected. Meanwhile, visitor arrivals should increase further as handling capacity continues to recover, with additional boost from the Government’s efforts to promote mega events.”
This wording suggests a positive outlook for the future, especially if US interest rates drop as expected and visitor arrivals continue to increase.
5. Potential risks for Hong Kong
What’s weighing on the Hong Kong economy is the interest rate environment. Since the Hong Kong currency is pegged to the US Dollar through a currency board arrangement, it effectively imports its monetary policy and interest rates from the United States. Here is a chart of the interbank rates currently prevailing in Hong Kong, also known as HIBOR:
Now that HIBOR has reached over 4% borrow rates for households and companies remain above the nominal income growth in the economy. In my view, that means that monetary policy remains restrictive.
We’ll see what happens to interest rates, but I personally believe that US interest rates will be coming down. Starwood Capital’s Barry Sternlicht recently pointed out that CPI is a lagging measure because it calculates rents with a 14-month lag. US inflation rates are coming down fast, and the Federal Reserve will likely react once CPI goes below 2.0% later this year. The Fed Dot plot is already pricing in rate cuts, and such rate cuts will directly lead to lower mortgage rates.
On that note, Hong Kong Chief Executive John Lee cut the stamp duty for purchasing residential property by half in October last year. This stamp duty was first introduced in 2010 and has been a primary reason why Hong Kong’s residential property transactions have been weak since that point in time:
However, given how dependent the Hong Kong government is on land sales, it’s possible that the stamp duty will be reduced to zero when the new budget is announced later this month. This would be a perfect time to do so, given the recent build-up in unsold residential in already-completed projects.
Lower interest rates and lower stamp duties should support the Hong Kong housing market. Which, admittedly, is still expensive at the current 3.5% cap rate.
Another challenge for Hong Kong has been the strong Hong Kong Dollar. China’s Renminbi has declined roughly 10% decline against the Hong Kong Dollar, causing as many as 200-300,000 Hong Kong people to cross the border each weekend, spending their money on Shenzhen restaurants and nightlife instead of in Hong Kong.
But if US interest rates drop in the future, it’s not implausible that the Hong Kong Dollar will yet again weaken against the Renminbi. I certainly would not assume that the current situation will persist forever.
Regarding the judiciary, a major risk is an update to Hong Kong’s National Security Law. The updated law could expand the government’s ability to prosecute residents for vaguely worded offenses like “colluding with foreign forces”, “publishing misleading statements” and close down civil society organizations. Chief Executive John Lee promises that people can still criticize the Hong Kong government and express their opinions as long as they do not endanger national security.
Reading between the lines, it sounds like you’ll still be able to say what you wish as long as you don’t challenge party supremacy.
Another longer-term worry is geopolitics. If a war were to break out in Taiwan or elsewhere, US sanctions could be imposed on Hong Kong. It could lose its special trade status. Import tariffs would be imposed, and it would be subject to the same export controls as China. If the Hong Kong Dollar were to be de-pegged to another currency. But as long as the currency remains freely convertible, Hong Kong will continue to retain its competitive advantage as a hub for raising overseas capital.
6. Hong Kong domestic small caps remain cheap
When I look at Hong Kong equities, I like to divide them into:
Companies with exposure to mainland China
Companies with exposure to other countries
Domestic Hong Kong companies earnings their revenues in Hong Kong Dollar
Above, I’ve tried to argue that China’s economy remains weak. The construction industry has imploded, and I’m unsure whether residential new starts will ever recover. Consumer confidence is weak.
But the Hong Kong economy is doing just fine. And if you believe that the Federal Reserve will cut interest rates － as I do － Hong Kong will be one of the prime beneficiaries in Asia. Domestic Hong Kong companies should do well in that scenario.
If you want to go the ETF route, there are several indices to choose from. But MSCI China has a large exposure to mainland Chinese companies. Hang Seng China Enterprises Index is similarly focused on mainland Chinese companies. Comparatively speaking, the Hang Seng Index is the one index that has slightly more exposure towards domestic Hong Kong equities.
Today, the Hang Seng trades at a P/E of 8.4x － close to its October 2022 lows and at a similar level as in the Great Financial Crisis of 2008. This number is extreme.
The top 10 holdings of the Hang Seng include HSBC, Alibaba, Tencent, AIA and a few other companies. And the P/E multiples for these companies are low as well:
If you want to track this index, two of the options are the iShares Core Hang Seng Index ETF (3115 HK) or The Tracker Fund of Hong Kong (2800 HK).
If you want to dig deeper though, you can find companies with almost no exposure to the mainland Chinese economy. Not only will you gain exposure to an economy that’s performing better, I also believe that Hong Kong offers greater safeguards for investors when it comes to corporate governance. I trust the numbers more.
In the past few days, I’ve gone through the list of the 1,500 or so Hong Kong-listed equities with market caps above US$50 million. I then tried to identify those those that little to no exposure to mainland China and put them in a separate tab called “HK-Overseas stocks” in the following spreadsheet.
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