18 October 2019
Weighed down by fears of a Grexit, the Hang Seng Index closed 827 points or 3.2 percent lower at 25,236 on Monday, the lowest in three months. Photo: HKEJ
Weighed down by fears of a Grexit, the Hang Seng Index closed 827 points or 3.2 percent lower at 25,236 on Monday, the lowest in three months. Photo: HKEJ

Why fundamentals are more important than market trends

As we can now find listed companies from various sectors in Hong Kong, industrial cycles have replaced economic cycles as the main market theme.

Investors should focus on specific stocks rather than minding too much the performance of the Hang Seng Index.

Before 1994, the Hong Kong market was mainly affected by economic cycles. All sectors benefited from economic prosperity, while recession dragged down all industries. Economic indicators provided a clue to whether it would be a bull or a bear market.

However, the market has entered a “stockpicker’s market” since 1994. Selecting the right stock is as important as the economic cycle. Some stocks are being increasingly affected by industrial cycles as well as the broader economy.

For example, the newspaper industry has been grappling with falling profits since 1994, and some red chips have been replaced by state-owned enterprises since 1997. Internet technology stocks were sought-after in 2000, but China SOEs have never returned to their peak in 2007.

PEG ratio and the stock price

The price/earnings to growth (PEG) ratio is a key factor determining the stock price. PEG is calculated by dividing the P/E by the projected earnings growth rate.

For example, the earnings growth of a company is below 10 percent, and its P/E ratio stands at 12 times. If its earnings growth increases to over 15 percent, its P/E ratio would rise to 18 times. If the earnings growth surges to over 25 percent, the P/E ratio could hit 25 times or even higher. However, the P/E ratio could slump to eight times or lower if the earnings growth failed to increase even fall back.

That’s why high-growth stocks usually see their share price constantly rising as long as they sustain an earnings growth of 25 percent. However, the share price could plunge by 70 to 90 percent if the earnings growth fall back, and the P/E ratio could slump from 25 times to below eight times. The share price of a loss-making company could surge several or even 10 times if the company swings back to profit.

Bear and bull markets

I sold out all my shares when the Hang Seng Index hit 1,200 points in January 1973. However, the benchmark rose further to 1,774 points on March 9, 1973 before tumbling to 150 points in December 1974.

I entered the market at 470 points in July 1974 and suffered a huge loss by December. The lesson has taught me to “never estimate the peak during the bull market and estimate the bottom during the bear market”. Investors will never recognize there is a bubble until after it bursts.

Widening wealth gap

The wealth gap has kept widening in Hong Kong since 1994. By 2015, the top 1 percent of the population, the super-rich billionaires, control one-third of the city’s wealth, while another third of the wealth is in the hands of the top 10 percent rich people. The middle-class people, accounting for 60 percent of the population, have snapped up the remaining third of the wealth. Therefore, the poor people, or 29 percent, have nothing left.

With a good educational background, one still has opportunity to join the middle class after many years of hard work and promotion to senior management positions. And if you want to become the top 10 percent of the population, you have to rely on investment or start your own business. The extremely wealthy 1 percent usually inherit their fortune.

Meanwhile, the poor 30 percent have to depend on government subsidies and apply for public housing, but getting married or having kids are too expensive for most of them.

Given this blatant wealth gap, public resentment may not disappear anytime soon. However, an immature democratic system may even hamper economic growth, as we’ve seen in the Philippines, Thailand, Indonesia and India.

This article appeared in the Hong Kong Economic Journal on July 4.

Translation by Julie Zhu

[Chinese version中文版]

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Chief Adviser at the Hong Kong Economic Journal