The Hang Seng Index has come off more than 5,000 points from its January peak, with many sectors suffering heavy sell-offs. As the price-earnings ratio of the market is currently at below 12, one can ask this question: are the stocks really cheap now?
Although P/E is a popular gauge, it is not really a reliable metric.
P/E can be distorted in many ways. For example, real-estate firms’ reported profit often includes huge property valuation gains. Banks’ profitability could be overstated if their bad debt provision level is inadequate.
Also, perpetual bonds issued by Chinese developers are not categorized as liability, so the interest expense is not reflected in the bottom line. Industrial companies can manipulate the amortization period of fixed assets to boost their profitability.
By contrast, the Statement of Cash Flow tells more truth as cashflow can more faithfully reflect a company’s profitability.
If a company has a profit of HK$1 billion, but it posted a negative operating cashflow of HK$1 billion, something must be wrong.
Cashflow also determines dividend paying ability, although the management has the final say how much dividend they want to pay to investors.
So I would suggest dividend payout rate as a better valuation yardstick.
The dividend rate in Hong Kong market largely hovered between 2 to 5 percent historically. It’s generally a good time to buy if it rises above 5 percent.
Currently, the Hang Seng Index stands at a little below 28,000 points, with dividend rate at around 4 percent.
For the dividend rate to reach 5 percent, the index needs to drop to 22,000 points. Extremely low valuations are often found during economic recessions, with corporate earnings and dividend dropping at the same time.
To build in a margin of error, 20,000 to 22,000 points should be a strong support zone.
Meanwhile, the market has continued to fall over last few weeks despite satisfactory interim results, reflecting investors’ concern about macro headwinds.
Dollar strength has put pressure on China’s renminbi currency. That would affect the Hong Kong dollar-denominated profit of Chinese companies.
The US-China trade war is unlikely to end anytime soon, a factor that has prompted mainland investors to sell Hong Kong stocks and boost their cash holdings.
Meanwhile, the US and China are both tightening their monetary policy, something that will also weigh on equities.
As long as these headwinds continue to persist, Hong Kong equities may stay under pressure.
This article appeared in the Hong Kong Economic Journal on Aug 22
Translation by Julie Zhu
[Chinese version 中文版]
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