HK stocks; Dollars trading for Pennies

On the Hong Kong stock exchange, several profitable, dividend-paying businesses are trading below their net-cash balance. The value becomes really absurd, when we also include financial assets.

Overview; Net-Nets

In the table below, you find some of the most bizarly valued stocks, I came across on the Hong Kong stock exchange. This is strictly for illustrative purposes. There are a lot more cheap-looking stocks where these came from.

Most of the columns should be straight-forward. The column P/FAV indicates the Stock price (P) divided by Financial Assets Value (FAV). Financial assets consist of the company’s net-cash/debt balance and the value of other financial assets such as investments in securities, associates, and investment property. P/FAV basically tells you how many cents/pennies it costs to buy 1 Hong Kong dollar (HK$) worth of financial assets. Notably, this does not award any value to the operating business activities. Tianjin Development Holdings ($882.hk), for example, trades at 19 cents at the HK$1. We can also turn it around, and say that the financial assets value is worth over 5x more than the stock price.

The overview above is strictly an indication of value. By no means have I tried to be precise in this exercise. Perhaps I will leave that for a follow-up post. The net-cash balances may be overstated for liabilities I did not properly take into account. The investments may be worth substantially less (or more) than the (usual reported carrying value) that I used.

Just to continue with the Tianjin Development example, its 16.55% ownership interest in Otis Elevator China was included for HK$ 980m in the 2022 balance sheet. I applied a value of HK$ 1,300m, assuming a P/E multiple of 4x. That valuation would put it at a 25% dividend yield for that year. If we use the book value for Otis instead, then Tianjin’s FAV/share would be HK$ 0.30 lower. Quite meaningful on Tianjin’s stock price of HK$ 1.44.

Diego Milano did some great write-ups on Tianjin Development and First Pacific ($142.hk) in the Letters to Shareholders of the Quercus Fund.

Why so cheap?

As we learned in the previous post - Imperial Petroleum; Fighting Net-Net status? ($IMPP) - a very low valuation tends to come with a good reason. In $IMPP’s case, the over 80% discount to net asset value (NAV) was the result of the CEO’s belligerent abuse of minority shareholders to enrich himself.

There are definitely reasons why Hong Kong stocks should trade at a discount to fair value. Just to name a few;

• Geopolitical and macro risks exacerbated by worsening relations between the U.S. and China.

• Frauds; HK has had more than its fair share of them, at least that is the perception

• Trading suspensions; there are various examples where the HK exchange has suspended stock listings for violations of the listing rules… sometimes for years. Trading in Brilliance China Automotive ($1114.hk) - BMW’s joint venture partner - was suspended from 31st March, 2021 to 4th October, 2022.

• Governance and capital allocation issues; many HK/Chinese companies have a controlling shareholder. Outside shareholders have very little influence, and may just have to swallow how capital is allocated serving the controlling shareholder, instead of being value-creative for all shareholders.

The current discount in some stocks looks far too high to me. Some of these discounts have, however, been around for many years, and it is hard seeing what could quickly reverse that situation.

Catalysts to unlock the value?

Catalysts to unlock the value can come in many different shapes and forms. Sometimes it is just a simple as things stop becoming less bad, or things looking less bad than initially perceived/feared. This was the case in Brasil and Colombia. Investors sold off stocks of state-owned companies, such as Petrobras and Ecopetrol, due to fears for the new presidents. Subsequently, stock returns have been strong as it became clear that the fears were overblown.

Improving economic conditions and/or relationships between China and the U.S. could go a long way in restoring faith in HK stocks.

One of the most obvious catalyst I see at the moment, is a government push to make stock investments more attractive;

• China’s securities regulator is asking publicly traded companies to boost dividends to reward investors and said it will increase supervision of those that do not pay. China Securities Regulatory Commission said it will strengthen disclosure requirements for companies that are not paying dividends. It also encouraged listed firms to increase the frequency of their dividend payouts and streamline interim distribution processes.

• The Hong Kong government recently reduced the rate of stamp duty for the sale or purchase of any Hong Kong stock from 0.13% to 0.10%.

These measures have parallels to what has been happening in Japan.

What to buy?

With Hong Kong listings, there are a few criteria I pay special attention to in selecting stocks.

• Governance; the Hong Kong exchange has the nasty habbit of issuing trade suspensions on stocks, where the exchange rules have been violated. These trade suspensions sometimes last for months, or even years. Making a mistake by skipping a basic governance check can therefore haunt you a lot longer with stocks in HK vs stocks on other exchanges.

• Capital returns and Distributable reserves; Capital returns do several wonderful things for shareholders. First of all, consistent strong dividends can demonstrate an ability to pay. It therefore, signficantly reduces fraud risks. They also provide a direct investment return … while waiting for a share re-rating for instance. Moreover, they make capital more scarce for the management to splurge on investment spending, typically limiting capital spending to the better ROIC projects.

  Something particular for Hong Kong/Chinese stocks are the “Distributable reserves”. In the United States, companies can pretty much distribute as much money as they can fund. Even, if that creates a negative equity position on the balance sheet in the process. In Hong Kong, on the other hand, companies are not allowed to return more capital to shareholders than the distributable reserves. To prevent the nasty surprise of a dividend cut, a basic check should include the status of the distributable reserves.

  I noticed few companies with a straight-forward dividend policy. Tianjin Port Development Holdings Ltd ($3382.hk) (not to be confused with Tianjin Development Holdings) is one the exceptions with a dividend policy stating the intention to declare annual dividends between 30% and 50% of the profit attributable to Shareholders each year. Most of the time, you will not get too much predictablity on future dividends.