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Six contrarian bets in Hong Kong
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Hong Kong’s stock market index Hang Seng has been flat for almost 15 years at this point. The Hang Seng’s price/book ratio is now 1.0x - the same level as during the bottom of the Asian Financial Crisis in 1998:
While Hang Seng’s index composition has changed over the past 15 years, I think it’s safe to say that many Hong Kong stocks are inexpensive.
Investors fear is that Hong Kong will become absorbed into mainland China and adopt socialism with Chinese characteristics. I don’t dispute that - but life will go on, for the most part.
This post will outline how I think Hong Kong will change in the next 10-20 years. I will then end the post with a few stocks that I believe will do well thanks to or despite this new environment.
Hong Kong’s competitive advantages
As far as I can tell, Hong Kong has three competitive advantages:
Contractual freedom: Courts have historically been independent and property rights secure.
Low tax rates: Hong Kong’s tax/GDP ratio is among the lowest globally, providing a hospitable climate for entrepreneurs and wealthy individuals.
The Hong Kong Dollar: Unlike the Renminbi, the Hong Kong Dollar is pegged to the US Dollar and freely convertible. The convertibility of the Hong Kong Dollar provides the People’s Republic of China access to foreign currency.
I think the great irony of Hong Kong is that while the city is seen as a capitalist mecca, much of the wealth has come from trading with its Communist neighbour up north.
As described by shareholder activist David Webb in a 2018 essay:
“Hong Kong, while it is not a state conglomerate, is also a parasitic economy that has benefitted hugely from the constraints on freedoms in China by acting as an entrepôt and running the only international capital market on Chinese soil.”
So Hong Kong is, in a way, a bet on the slow pace of reform in mainland China. The longer the Renminbi remains non-convertible, the more Hong Kong will cement its edge as an overseas capital market for Chinese companies.
Likewise, as long as Hong Kong maintains its low import tariffs, mainland Chinese will continue to flock to the city’s shopping malls. And as long as tax rates are low, Hong Kong will remain an attractive city to live in.
After the handover of Hong Kong territory to the People’s Republic of China in 1997, a promise was made to maintain Hong Kong independence for another 50 years until 2047.
With Hong Kong’s 2020 national security law, it’s becoming clear that policy convergence will happen far sooner than initially planned.
The implications of the national security law are massive, I think. Any action deemed to be against the country's or the Communist Party’s interests could, in theory, be punishable by law. Beijing will get its wish across in many domains.
To begin with, schools will adopt a patriotic curriculum, and retroactive film censorship laws are coming. Trade unions have been disbanded. There are now signs that Internet censorship is coming to Hong Kong as well. The experience of living in Hong Kong will become much like that on the mainland.
A coming redistribution of wealth
Xi Jinping’s primary focus over the next decade will be to achieve “common prosperity” for the country. In other words, wealth redistribution. Not only in mainland China but also in Hong Kong.
China’s liaison office in Hong Kong recently said that the government would try to:
"Implement more precise and effective measures to gradually solve important livelihood problems, such as employment, income, land, housing and medical care, which can solve the deep-rooted conflicts that affect citizens' lives."
One mechanism to redistribute wealth could be higher tax rates within Hong Kong. The higher tax revenue could be used to build the large-scale public housing and infrastructure projects that the government has announced.
But by raising tax rates, Hong Kong competitiveness compared to Singapore and Dubai will inevitably be diminished.
Hong Kong’s companies will probably also be asked to contribute to this redistribution of wealth. On the mainland, powerful large companies such as Alibaba and Tencent have been compelled to donate large sums of capital as “social contributions”.
As one mainland economist commented in Chinese state newspaper “China Daily”:
“What [Hong Kong] can and must do is enhance the third distribution of wealth, which goes to nurturing and developing the social charity sector. Normally, big businesses with a matching sense of social responsibility constitute the mainstay of the social charity sector. Recently, Shenzhen-based tech giant Tencent Holdings announced a “sustainable social value innovation plan” worth 50 billion yuan (US$7.7 billion), followed by another 50-billion-yuan startup fund for a “common prosperity special program”. It is hoped Hong Kong-based conglomerates will do the same one way or another.”
I suspect that Hong Kong tycoons will soon be forced - one way or another - to donate large sums of money to government-controlled charities.
The population is likely to drop (temporarily)
Emigration has picked up since the new national security law came into effect in mid-2020. Roughly 1.4% of the resident population left the city in the first year of the new law, causing Hong Kong’s overall population to drop.
The decline could partly be related to COVID-19. But regional peer Singapore has seen its population stay roughly flat during the same period. So the problem seems to concern Hong Kong specifically.
Independent surveys have concluded that roughly 10% of Hong Kong’s population plans to emigrate, so expect large-scale emigration to continue.
A decline in Hong Kong’s population could, in theory, be offset by immigration from the mainland. However, a few short-term hurdles exist for mainland immigration:
Many mainland Chinese no longer feel welcome in Hong Kong due to local antipathy towards them.
From 2020, mainland Chinese working in Hong Kong have been asked to pay additional Chinese income tax. That means that mainland Chinese will suffer both from Hong Kong’s high living expenses and a higher tax rate than Hong Kong locals.
These hurdles can be overcome over time - especially since salaries in Hong Kong tend to be higher than those on the mainland.
But in the near term, I believe that we should probably expect Hong Kong’s population to continue to shrink.
Foreign talent will move elsewhere
Several reforms are likely to scare off international talent from Hong Kong.
A new law makes it such that Hong Kong SIM cards will be linked to people’s identities, increasing the risk of government surveillance of personal data.
The government has begun refusing visas to journalists. In response to greater difficulties of obtaining visas, the New York Times moved its regional headquarters to South Korea.
Mainland private companies and multinationals with subsidiaries in China have been forced to adopt Communist party cells with indirect say over corporate strategy. Such policies are likely to be extended to Hong Kong.
Hong Kong’s COVID-19 restrictions now resemble those on the mainland, with requirements of 14 days of quarantine in a hotel followed by seven days of self-quarantine at home. Many find these requirements onerous compared to much lighter regulations in Japan and Singapore.
A July 2021 survey of finance professionals by Selby Jennings showed that 69% of those surveyed in Hong Kong were eager to move to Singapore.
So while Hong Kong has historically been the default choice for top Asia-Pacific roles, there is now a net outflow of multinationals headquartered in the city. 47 foreign regional headquarters have moved out of Hong Kong so far this year.
Meanwhile, the number of mainland Chinese companies in Hong Kong has increased. It’s becoming evident that overseas professionals will increasingly seek to live elsewhere in the region, including Singapore and Japan.
Future oversupply in residential property
A 2017 Communist Party document outlined plans for Hong Kong to become part of a “Greater Bay Area” of Hong Kong, Macau and parts of China’s Guangdong Province.
To achieve this dream of a Greater Bay Area, the government is building large-scale infrastructure projects, including bridges and highways.
The Hong Kong government is also encouraging young Hong Kongers to move across the border and become accustomed to what it’s like living on the mainland.
A new “Northern Metropolis” of government-subsidized housing will be built just in New Territories. The plan is to raise the population in the North and Yuen Long districts from 1 million to 2.5 million, putting these new residents close to Shenzhen. The government plans to build half a million new homes.
It sounds to me that the combination of large-scale emigration and new government housing projects such as Lantau Tomorrow and the Northern Metropolis is likely to lead to an oversupply of residential property.
The Hong Kong-China border will soon open
Hong Kong’s economy has been weak since 2019. Today retail sales numbers remain 30% below 2018 levels.
The first hit to Hong Kong’s retail sales came from a drop-off in tourism from mainland China due to anti-government protests in the city.
The second hit came from COVID-19, with overall passenger arrivals dropping to almost zero:
The lack of inbound tourism has had a significant impact on the medicine and cosmetics industry, where revenues more than halved:
Other sub-sectors within the retail industry have done better:
Supermarket sales have been more or less flat since the pandemic started.
Restaurant receipts were weak during Hong Kong’s lockdown but have now partially recovered.
The main culprit behind the weak inbound arrival numbers has been Hong Kong’s zero-tolerance policy regarding COVID-19. Arrivals need to stay in quarantine for 7-14 days, placing a significant burden on individuals that travel back and forth.
There are no signs that Hong Kong will ease its quarantine policy for international travellers. But I am convinced that the Hong Kong-Mainland border will open up very soon.
As Carrie Lam said recently:
“Of course, international travel is important, international business is important, but by comparison, the mainland is more important.“
Beijing officials are working hard to open up the border within the next eight months. The border reopening will start in December 2021 and be finalised by June 2022, according to the following suggested schedule:
December 2020: Small pilot program with quotas of a few hundred people per day being able to cross the border
February 2021: An expanded sizeable daily quota to at least a few thousand
June 2021: Several of the ten land checkpoints will fully reopen, without subjecting travellers to quarantine - provided they meet certain conditions, including vaccinations
Once the border has reopened, Hong Kong is likely to retain its current zero-tolerance policy to COVID-19. Any new COVID-19 infections would then lead to renewed border closures and lockdowns. But as long as case numbers remain under control, the opening up of the border to the mainland could well lead to a partial recovery in Hong Kong’s retail sales.
A few Hong Kong stocks that I find attractive
With that out of the way, here are a few stocks that I think are undervalued given the above backdrop.
Bet #1: CK Hutchison (1 HK)
Li Ka-Shing’s holding company CK Hutchison is a large conglomerate operating in several different industries. It has exposure to retail through its Watson’s chain of health & beauty stores, oil & gas through Cenovus and Husky energy, sea ports through container terminal operator Hutchison and European telecom through “3 Group”. Cheung Kong infrastructure also has a number of minority investments in energy, water utilities, power grid assets and waste management.
Li Ka-Shing’s property business “CK Asset” (formerly CK Property) is now a separately listed entity. While CK Asset has significant exposure to mainland China, CK Hutchison only has about 10% of its revenues from the mainland. CK Hutchison should be seen as a globally diversified conglomerate.
By sector, CK Hutchison has roughly 34% of its NAV in infrastructure (toll roads, water utilities, power grids), 24% of its NAV in wireless telecom, 22% in retail, 15% in container ports and the rest in oil & gas.
Retail has suffered from a lack of Chinese tourism to Hong Kong. The oil segment has suffered from low oil prices during the pandemic. A reversal of those two negatives could be catalysts for the revaluation of CK Hutchison’s shares.
Adding up the value of underlying assets attributable to CK Hutchison, you get to a number between HK$500-600 billion. That’s a conservative estimate. My number is closer to HK$575 billion.
Deducting CLSA’s estimate of corporate-level net debt of HK$166 billion, I get to a net asset value of HK$408 billion or NAV/share of HK$106. Deducting a discount of 25%, I get to a fair value per share of HK$80 and an upside of +52%.
Given that CK Hutchison is currently repurchasing up to US$1 billion worth of shares, the upside could become more significant than that.
The main risk is that CK Hutchison would be forced to donate large sums of money to the Hong Kong government in the name of “common prosperity”. Chinese state media have in the past lashed out at Li Ka-Shing for selling assets on the mainland and investing overseas instead. Li Ka-Shing is now the only Hong Kong tycoon who does not rely on the Chinese market for his wealth.
At a market cap of HK$200 billion vs an underlying net asset value of HK$408 billion, I believe that a worst-case scenario has already been priced-in.
Bet #2: NWS (659 HK)
NWS is the infrastructure services company of the New World Group. During the fiscal year of 2021, NWS had 43% of its attributable operating profit from toll roads, 23% from insurance, 22% from construction and 12% from aviation. NWS’s is almost free from corporate-level debt.
NWS has four anchor expressways: the Hangzhou Ring Road, the Tangjin Expressway, the Guangzhou City Northern Ring Road and the Beijing-Zhuhai Expressway. The average remaining concession period is only 10 years, in line with many other mainland Chinese toll roads. So valuing them much above 6x P/E would be aggressive, in my view.
The aviation business has to do with aircraft leasing. The fleet is young at just 5.4 years and in demand with a high utilisation rate. The average remaining lease period is 5.6 years. The aircraft leasing segment did poorly in 2020 but has now started to recover.
The insurance segment was consolidated from the 2019 acquisition of FTLife Insurance. This segment suffered during COVID-19 due to a lack of visitors from mainland China.
NWS’s other businesses include managing the Hong Kong Convention and Exhibition Centre, duty-free stores at cross-border terminals in Hong Kong & Macau, hospital group Gleneagles Hong Kong, a Hong Kong bus & Ferry operation and construction business Hip Hing Group. NWS also owns container ports, coal-fired power plants and a logistics business.
I believe that NWS’s normalised earnings will end up at around HK$5 billion, which, compared to the current market cap of HK$30 billion, puts the stock on a P/E ratio of 6x. A doubling of the share price from the current level is not unreasonable, while you’ll be able to collect 8% in dividends every year. A NAV calculation with a 25% discount puts the value per share at HK$14.4, implying close to 100% upside. These numbers are conservative - valuing the roll roads at just 6x P/E, the aircraft leasing segment at 8x and the construction segment at 5x.
Again, the main risk of being a conglomerate in Hong Kong is being forced to contribute one way or another to the government’s common prosperity drive. New World’s second-generation Henry Cheng had been “poker buddies” with Evergrande chairman Hui Ka Yan, though it’s not clear whether this connection will have an impact on New World or its subsidiaries such as NWS.
41-year old third-generation leader Adrian Cheng Chi-kong on the other hand, serves as vice-chairman of the Communist Party’s All-China Youth Federation and a member of the political organ Chinese People's Political Consultative Conference. He has been cultivating relationships with Communist Party officials in Beijing.
Among Hong Kong’s other conglomerates, Jardine Matheson seems to have done the best in Hong Kong’s recent stock market slump. Swire Pacific is down due to its ownership of Cathay Pacific, which sucks up cash. Swire’s property and beverage businesses are doing better. Wharf is mainly focused on property development - a sector that I’m not particularly bullish on.
Bet #3: Dairy Farm (DFI SP)
I discussed Jardine Matheson subsidiary Dairy Farm in this prior deep-dive. The company runs a number of grocery stores and pharmacies throughout North and Southeast Asia, using the brand names 7-Eleven, Cold Storage, Wellcome, Giant, Marketplace, Guardian and Manning.
The truth is that much of Dairy Farm’s profitability before 2019 came from its pharmacy segment, in particular from the Mannings chain in Hong Kong. Significant business from “daigous” (agent buyers from mainland China) might have been a part of the explanation. Before 2019, mainland residents would travel to Hong Kong to stock up on medicine and other pharmacy products, knowing that Hong Kong products would be high-quality and authentic.
After mainland tourism trickled to a halt in the autumn of 2019, Dairy Farm’s profitability plummeted. It has yet to recover. Now that the border is finally opening up again, there is finally light at the end of the tunnel.
With pre-2019 profitability around US$400-500 million and a current market cap of US$4.5 billion, one can probably assume that a normalised P/E multiple will be around 10x. To me, that’s attractive given the calibre of people that are running Dairy Farm. I’m less concerned about the near-term threat from e-commerce than many others. The stock has historically traded at a P/E multiple of 22x.
I’m having more difficulty finding undervalued stocks in other parts of the Hong Kong retail universe. The three jewellery chains Chow Tai Fook, Luk Fook and Chow Sang Sang are all doing brisk business thanks to the money printing that has occurred since the pandemic began in 2020. Out of the three, Chow Sang Sang does seem the most undervalued. But the company appears to be suffering from intra-family conflict. Cosmetics retailers Sasa could plausibly do well in a scenario of improving cross-border tourism. I’m not sure whether Sasa’s normalised P/E ratio of 11x is low enough to take the plunge. The largest watch retailers Oriental Watch, Emperor Watch and Hengdeli are doing very well right now, with consumers spending their COVID-19 cash hand-outs on luxury goods. But Oriental Watch has already re-rated quite a bit, and the two latter have issues with corporate governance.
Bet #4: Hysan Development (14 HK)
From 2013 to 2015, I spent a lot of time understanding the Hong Kong real estate industry, travelling back and forth on an almost monthly basis. One of the best-run companies that I came across during this period was Hysan Development, which owns several high-quality properties in Causeway Bay. These properties include Hysan Place and Lee Garden. High profile retailers such as Apple and Eslite have chosen Hysan Development as their partner shows how professional the company is.
Hysan’s portfolio in terms of net leasable area is divided into 49% office, 43% retail and 8% residential. COVID-19 has impacted the office market. Recovery would require a reversal of the work-from-home trend. Waiting for this to happen will require patience. Hysan’s office tenants are geared towards banking, insurance, technology and consulting companies.
While the retail property market has been affected by e-commerce, Hysan’s malls are more geared towards tourism and experiences. As mainland tourists tend to be attracted to Causeway Bay, having shops in Causeway Bay is more about brand building and marketing than store-level sales.
Hysan’s retail portfolio turnover has dropped since 2018. The number of global search queries on Google for “Causeway Bay” is up about 10% from the 2020 average but still down 40% from pre-pandemic levels. Since August, there has been an uptick in Lee Garden’s website traffic for reasons that are not clear to me.
Hysan Development’s valuation multiple compares favourably to its peers and its history. It now has a P/E ratio of 13x compared to a historical level of 19x. The stock is down about 40% since the peak in 2018. Hysan’s EV/EBITDA is among the lowest in the sector as well.
Comparing Hysan Development with its peers, it’s clear that Link REIT is a very expensive stock. Link REIT focuses on regional malls and also has significant car park exposure. Link REIT’s revenues are therefore more stable than those of Hysan Development. Hang Lung Group has 60% of its assets on the mainland and the rest in Hong Kong. Within Hong Kong, Hang Lung owns several high-quality assets, such as the Peak Galleria and Grand Plaza on Nathan Road. But Hang Lung’s debt levels are very high. Fortune REIT is a regional mall operator with assets of varying quality. Altogether, I find Hysan’s assets to be the most attractive, though with significant exposure to tourism from mainland China.
Bet #5: Miramar Hotel (71 HK)
Miramar Hotel’s pre-pandemic revenues were split into 44% from a travel agency business, 30% from property rental, 18% from serviced apartments and the rest from food & beverage.
The property rental business is a mix of retail and office in Hong Kong, primarily via Mira Place 1 & 2 on Nathan Road in Kowloon. Close to Mira Place, the company owns a hotel called Mira Hong Kong with 492 rooms. Given Mira Place’s strategic location on Nathan Road, the shopping mall is a natural destination for Chinese tourists.
The Miramar travel agency helps sell cruise ship tickets and organised trips to Europe and across Asia.
Miramar is unique because the company has been profitable throughout the pandemic and has a significant net cash position. This cash could one day be deployed into new investments. With an EV of HK$3.8 billion and pre-2019 EBIT of close to HK$1.0 billion, it has a potential recovery EV/EBIT of 3.8x and a dividend yield of 5%. Exclude the cash, and the upside will narrow. But I still think that the risk-reward is highly skewed to the upside.
While I’m impressed with Miramar’s management team, the stock is unfortunately illiquid. Kadoorie-backed Hongkong & Shanghai Hotels is significantly more liquid, though not as cheap and also highly indebted. Hongkong & Shanghai Hotels owns a great set of assets, including the Peak Tram and the Peninsula Hong Kong. Associated International Hotels - the owner of the shopping mall iSquare on Nathan - also looks undervalued. Unfortunately, the stock is illiquid and only suitable for small accounts.
Bet #6: Fairwood (52 HK)
Chinese-cuisine fast-food chain Fairwood trades roughly 50% below its 2018 high, despite a strong net cash position. Fairwood company runs 98 fast-food outlets in Hong Kong, serving over 100,000 customers per day. The restaurant chain seems to be popular with Chinese tourists. The food is not fancy but acceptable given the price.
The company was started by Dennis Lo Fong-cheung - the brother of Vitasoy founder Lo Kwee-seong and also the brother of Café de Coral founder Victor Lo Tang-seong. I don’t think Fairwood has been affected by Vitasoy’s fallout with Beijing. Still, Fairwood’s relationship with the Chinese Communist Party is an important question that I have not fully understood.
While Café de Coral remains a larger business, Fairwood seems more nimble in its capital allocation and strategic decision making. The company’s return on equity has been well over 20% for many years. In addition, Fairwood has a track record of buying back stock. And the dividend payout ratio has been generous at around 80%. Fairwood also dealt with the pandemic well by putting a greater focus on take-away food, enabling a partial recovery in revenues.
Fairwood made HK$1.7/share in EPS before the anti-government protest broke out in 2019. Against today’s price, that would put the stock at P/E ratio of 10x. Within Hong Kong, Fairwood plans to add 12-13 branches. Within the Greater Bay Area, Fairwood intends to add 30 outlets by the end of 2022. Another catalyst could be a potential dividend hike from the current low levels.
I believe that you will do well with either Café de Coral or Fairwood. The menus are similar, and both companies have brand names that are well-known throughout Hong Kong. Café de Coral has historically enjoyed a higher P/E multiple but a lower return on equity. I’m noting significant insider buying in Tai Hing and Tang Palace. While these two stocks are illiquid, they trade at very attractive levels.
Over the long run, it seems likely that Hong Kong will become a lot more like other Chinese cities. But life will go on. Local service companies, including regional shopping malls, fast food restaurants, pharmacies, grocery stores, etc., will do well over the long run.
In the short- to medium-term, there is a risk that a drop in Hong Kong’s population will hurt GDP+ industries such as advertising or regional shopping malls.
On the other hand, the upcoming border reopening will likely benefit Hong Kong’s retail industry, especially the sub-segment targeting mainland tourists.
Given the government’s plan to crack down on local tycoons and the plan for large-scale public housing projects, I believe that you’ll want to avoid residential property developers.