The risks and rewards of the Hang Seng Index

January 4, 2011

A panel displays the twenty most active Hong Kong shares (R) at the Hong Kong Exchange November 23, 2010. REUTERS/Tyrone Siu/Files

(The views expressed in this column are the author’s own and do not represent those of Reuters)

At the beginning of every year, there are always certain stocks that look attractive to me and these stocks invariably become my darlings of the year.

Entering 2011, a number of investors have asked me which stocks are going to be this year’s loves. Unfortunately, however, I have not found any.

In fact, I find the blue chip stocks that are listed in Hong Kong to be trading fairly, and many of them offer very little margin of safety to speak of. With that in mind, however, the broader market, namely the Hang Seng Index (HSI) is trading at an attractive level, and it has quite a considerable margin of safety to offer.

Although these two statements may seem contradictory, my rationale for making them is very much based on the risks and rewards of the HSI as a whole rather than on those of its index members.

The current P/E ratio for the HSI is trading at roughly 14x. Historically speaking, the index is considered fair at 14x to 15x. With market analysts assuming solid 15 percent to 17 percent earnings growth in 2011, the forward P/E ratio for the HSI will be around 12x.

At first glance, the index is tempting. Its theoretical value, which is based on expected interest rates, earnings growth, and its risk premium compared to that of other investment classes such as bonds and real estate, suggests that the index can reach 28,000 or above.

Looking at the HIS’s constituents, however, it becomes very difficult to judge which stocks will safely and soundly provide risks and rewards similar to those of the index itself.

For example, the top 10 stocks on the HSI account for almost 60 percent of its total value. Of these 10 stocks, six are financial service-related companies: HSBC, China Construction Bank, Industrial & Commercial Bank of China, Bank of China, China Life Insurance, and Hong Kong Exchanges and Clearing Limited (HKex).

Taking the Chinese banks as a case study, the forward P/E ratio is 9x to 10x. This sector certainly looks attractive and may be a good pick, but it is not necessarily a safe bet.

Due to industry-specific risks, investors are unable to judge how the fear of rising inflation will affect interest rates, which will indirectly affect banking earnings dynamics; or how policymakers will intervene in bank lending targets by controlling monetary and fiscal policies.

Nevertheless, if the Chinese bank stocks rally, then they will contribute positively to the HSI. Cherry picking the specific bank that will outperform the market, however, remains anybody’s guess.

Aside from unsystematic risks, stocks that are fairly or richly valued may also not be ideal investment picks, although that does not mean they will not perform positively.

The HKex provides a good example. At a forward P/E ratio of over 30x, its stock price is primarily driven by general market sentiment and the daily headlines.

As many stock analysts prefer to focus on the exchange’s daily turnover rather than the value of the company itself, betting on it seems more like speculation than true investment.

That said, however, if market sentiment turns rosy in the months ahead, then the HKex will continue to rise, thus benefiting the HSI as a whole.

The goal of the prudent investor is to generate returns while maintaining an acceptable degree of risk. It seems to me that in 2011, the risks and rewards of buying the HSI as a basket will minimise many industry-specific and stock valuation risks.

The best game plan for the year ahead may thus be to heed Benjamin Franklin’s advice: “We (the market) must all hang together or we (as individual stocks) shall most assuredly all hang separately”.

(You can e-mail Ronald Chan at ronald@chartwell-capital.com.hk)

(The above article is not intended to be a financial advisory. Readers must seek specific advice from experts before making investment decisions.)

No comments so far

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

[…] At the beginning of the year, I borrowed Benjamin Franklin’s wit and wrote that “we (the market) must all hang together or we (as individual stocks) shall most assuredly all hang se…“. […]

Posted by Focusing on the fundamentals | Expert Zone | Report as abusive