Focusing on the fundamentals

July 4, 2011

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

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 separately“.

What I was implying at the time was that Hong Kong stocks were trading only fairly, with many of them offering little margin of safety to speak of.

I further commented that the broader market, namely, the Hang Seng Index, was more attractive as a whole because it provided investors with more balanced risks and rewards than would the handpicking of its component stocks.

As we have now reached the mid-point of the year, it is crucial that we evaluate the current market condition and make necessary adjustments. After all, as economist John Maynard Keynes famously said, “When the facts change, I change my mind”.

A review of the Hang Seng Index shows it to have performed worse than anticipated, dropping 2.77 pct to 22,398 points as of the end of June.

Although such a decline seems trivial, the directionless market has been like a pirate ship ride at an amusement park, swinging within a 3000-point range for the past six months and throwing many stocks off course.

Many component stocks have indeed dropped much further than the Hang Seng Index as a whole.

For example, of the index’s 46 component members, 30 were in the red at the end of June, and 21 of which have fallen by much more than 5 pct. Stocks such as Esprit Holdings, Li & Fung, Cathay Pacific, and China Life Insurance closed the period down by over 15 pct.

On the brighter side, 16 component stocks have performed positively, although only 8 of them have posted meaningful gains exceeding 10 pct. Tencent Holdings, Belle International Holdings, and China Unicom are among the rare few posting more than 20 pct upside.

With news headlines recently highlighting the Greek default, rising inflation, the economic slowdown, and the earthquake in Japan, investors have certainly been wary of the poor market sentiment over the past months.

However, the value conscious investor knows that market sentiment can be temporary; it is the market’s fundamentals that ultimately count.

Delving into the Hang Seng Index in greater depth, we see that its earnings growth estimate for 2011 is around 15 pct — this was the case at the beginning of the year, and is still the case now. With a forward P/E ratio of around 11.8x, it is attractive compared to its long-term average of 14.5x.

Many economists believe that corporate earnings growth will remain intact for the rest of the year and that interest rates will remain low for the foreseeable future due to the slow economic recovery in most developed countries. They are also hopeful that inflation in China will be tamed in the second half of the year.

If all of these assumptions hold, then the fair value of the Hang Seng Index remains around 28,000 points.

Although I still prefer the index as a whole due to its more diversified nature, many of its component stocks have fallen to a point at which they finally present some margin of safety. It requires only a little work for the prudent investor to dig out quality blue chips from the list of laggards.

Nevertheless, if history provides us with any hints, then patience is probably the key. Looking into the performance of various stock markets in 2010, we can see that many indices moved sideways in the first 9 months and then rallied with a vengeance.

For example, the Dow in the U.S. was down by 6.3 pct in the first half of 2010, before rallying 18.45 pct to finish the year positively at 11 pct.

The Hang Seng Index performed similarly last year. It was down by 8 pct in the first half, followed by a 14.4 pct surge to end 2010 with a 5.32 pct upside.

The market must again hang together now, or its stocks may yet 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)

One comment

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i agree with your assesment that the hang seng presents attractive value. the trigger for the upmove is likely to be a refocus on growth in china during the second half of the year – thereby pushing up both markets.

Posted by aditya107 | Report as abusive