Investing in HK stocks

What I have learned over the years

I think most (value) investors go through four stages:

• Stage 0: Buy stuff that goes up. Especially when a lot of people around you get rich from doing it.

• Stage 1: Invest in the future! Buy into some fancy exciting new technology that will become big some day! The Cathie Wood stage. Usually stage 1 and stage 0 go hand in hand.

• Stage 2: Buy at low PE multiples. Some are smart and skip the first two. This stage is not bad, it should lead to slight outperformance. Can be dangerous without wide diversification as a lot of them are value traps.

• Stage 3: Check list becomes a lot more sophisticated with more metrics like ROIC, receivables days and inventory turnover, margin expansion etc. Realise that low PE is not everything. More attention paid to qualitative metrics like moat.

If you invest in Western markets this would be enough, but not in Asian markets where the trust factor is a lot lower, and where ownership is more concentrated. In Japan and Hong Kong it is easy to find stocks trading at low PE ratios, with pretty decent ROIC’s when backing out excess cash. But a lot of them are value traps and their excess cash will never be paid out (if it even exists).

And if these stocks would be valued based on discounted cash flow that minority investors will receive, they can be quite expensive!

In the US there is always a chance an activist steps in, or something happens within a reasonable time frame, to unlock value. But not in Asia, since a lot of companies are controlled by the founder, who treats the company as his personal holding. Or because it is much harder for an activist investor to boot out management. For cultural reasons or simply because ownership is based on local political connections and rule of law is weak (eg: Nam Tai).

This means filtering for a track record of large dividends/buybacks is that much more important. And stocks often trade more on dividend yield and not so much FCF yield. Since most market participants seem to have a “I believe that cash is real until I see it appear in my brokerage account” attitude. A stock hoarding cash will almost always trade at a significantly lower multiple than a stock paying out 90% of FCF. A high dividend payout is also the best safety net against fraud.

Therefore it is important to have an extra strict checklist when investing in Asia.

So this is what my initial checklist looks like, it is significantly tighter than for Western stocks:

• Above average ROIC of at least 15-20%+. I calculate ROIC by dividing unlevered adjusted net income over: property plant and equipment (tangible or intangible in case of R&D investments) + receivables + inventory + cash buffer for working capital movements - payables - deferred revenue. Exceptions can be made for real estate type of assets.

• Solidly profitable for most of the last 5-10 years. Needs to have very good reasons for years it was not profitable.

• Revenue at least flat to slow growth trend, valuing terminally declining earning streams is difficult, since you don’t exactly know the extent of negative operating leverage.

• No tiny operating margins, at least 5-6%.

• High inventory and receivables turnover with an improving/flat trend. Receivables growing faster than revenue is large red flag!

• Net cash usually means little in Asia without a clear catalyst, it should be heavily discounted.

• Excess cash needs to be paid out regularly. No large dividend/buyback (50-60%+ of FCF) is a hard pass most of the time. FCF defined as cash generated after attractive growth capex/acquisitions.

• Excessive capex spent, way above D&A, without fast growth in cash flows is a large red flag.

• Who the auditor is doesn’t mean much. Major frauds have been committed under the noses of big 4 auditors on a regular basis.

• No sizable net share issuances after the IPO, despite having a net cash balance. Exceptions can sometimes be made here in case of acquisitions.

• Interest rate on debt needs to be reasonable.

• Only stocks with low to no debt.

• No significant red flags on company insiders (webb-site.com is a useful resource here).

• Never pay up for growth or perceived quality, so anything above 10-15x PE is off the list. Gravity of earnings multiples is much greater in Hong Kong. And true quality compounders are rare enough that false positives are too great a risk.

• Avoid freshly listed stocks, want at least 5 years listed.

Sometimes it is tempting to make exceptions for stocks that look really cheap. Or has a nice narrative attached to it. But I think that is usually a bad idea.

So when a stock gets through this list, I look at who owns it. Often it is either a controlled company by one or two large shareholders, or an SOE. The more controlled it is (with 75% being the limit in Hong Kong before insiders are forced to make a bid), the bigger the discount. Unless dividend payout is high and consistent. Most SOE’s tend to not make it through this checklist as they often have a low ROIC.

And the smaller the business is, the bigger the discount as well. As it won’t attract institutional investment. And fraud risk goes up significantly.

Then I look at the geography of business, This can be:

• Mainland China

• Hong Kong

• International

• Or a mix of above

Usually mainland China businesses deserve a larger discount and have the greatest fraud risk. Since it is easier to just take everything and disappear somewhere in China. If the business is in Hong Kong and it is controlled by a Hong Kong family, fraud risk is much lower. As the legal system in Hong Kong is much better equipped to deal with fraud than mainland China. And harder to run away if caught.

Then I do the qualitative stuff, evaluate what business they are in. If it is B2B or B2C. How easy is it to identify a moat? If it is an export business. How faddish and cyclical it is. How consolidated the market is, how niche, how mission critical the company’s product/service is for customers, what % of their customers' budget they are. How great technology risk is, etc. etc.

Finally, be extra careful with export companies, as HK exchange has a lot of those. They are a fertile ground for value traps. As these companies participate in labour arbitrage. And you never quite know when they run out of cheap labour. Or get outcompeted by companies in countries with even cheaper labour. The more developed a country becomes, the less leverage exporters generally have over the local labour force. And the more likely it is that margins will get squeezed at some point. And they can be hit hard by sanctions. Exceptions can be made for higher value add items though.

They aren’t as cheap as they look

If you go through all this, you will probably end up with a list of at least several dozen stocks. What I started doing in 2021 is putting them in a google sheet that looks like this (click to enlarge):

I use this table (especially upside/downside together with growth and dividends) as rough guidance to track what is excessively cheap at the moment. Future growth determines where the stock will probably trade between min and max upside %.

LTM normalised PE range is taken somewhat conservatively, based on the last ~5-10 years, where the stock traded most of the time. Kind of roughly eyeballed, taking out the large peaks and throughs that only lasted a couple weeks or months. This range determines min and max upside.

Upside max should be taken with a grain of salt, for example TK Group upside is unlikely to be 152% in the current economic environment. With uncertainty of China sanctions, cost inflation and demand for their high end plastic injection molding. So Upside min scenario is more likely than Upside max in the coming year or two.

And stocks like Jiashili or Pacific Textiles will likely keep trading at the lower end of LTM PE range as long as they cannot show steady growth and have operating cost uncertainty.

If there are significant enough red flags, then usually I avoid even with high min upside. If red flags persist, I will delete the stock from the list.

What is nice about this approach is that it makes investing more systematic, as figuring out from the top of your head if a stock is cheap historically is prone to error and bias. This is dynamic and it makes me less anchored to price. And puts a low PE ratio more in perspective.

It’s a lot quicker (and probably more accurate) than building a DCF model. As it has things like majority ownership, country risk mostly built in. I am assuming that the market is right most of the time, and a large part of excess returns are generated by mean reversion when fundamentals seem largely unchanged/improving.

Probably the biggest trap I used to fall in, was to just blindly buy stuff at a low PE ratio. A low/no growth exporter with a large net cash position, will rarely be valued above 7-9x earnings. So buying at 6-8x earnings is often not as much of a bargain as it may look like.

Comparing current valuation with historical valuation is probably the safest way to value a stock in a risky market like Hong Kong. If a stock has rarely traded above what seems like an excessively low PE multiple for years, there is probably a good reason for it, that you have not yet figured out!

Volatility

I think aggressively taking gains is really the way to go with Hong Kong stocks. The Hang Seng fell 50% in 1987 compared to 20% for the S&P. And on average every 2.3 years since 2007 there has been a 20-60% price drop. Twice the frequency of the S&P 500. So buying and holding a few stocks is not optimal in a market like this. And taking advantage of volatility can be very profitable if you don’t have to pay large capital gains and dividend taxes.

For example when Consun was trading at 6-8x earnings earlier in 2021 after they reported results, I sold my entire stake. As max upside was going negative, and there was still a lot of uncertainty about future growth. After I did this, two more chances were given to me to get back in very cheaply! This has been a nice trading stock as they have high margins and ROIC and return capital very aggressively through buybacks and dividends.

I don’t really make DCF models and then stubbornly hold until it goes to my FV estimate. I don’t wait until max upside is approaching 0%. When min upside goes negative, I usually start selling, unless I have a very high conviction about earnings growth. I don’t really care about calling a top. I never get married to one stock. When I sell, the alternative is always another cheaper stock, and not cash.

So the key is to always have good alternatives ready. Always having enough potentially cheap stocks to invest in makes it a lot easier to avoid unforced errors.

What is nice is that I am not really timing the market here. I don’t have to look for any head and shoulders patterns. I am purely trading based on historical valuation and mean reversion by treating them like coiled springs that spit out cash. Where I want to be in stocks with the most potential energy. As they start to lose that potential energy (min upside goes negative and/or max upside <40-50%) I start selling on the way up. And vice versa. And I want to get paid well in dividends and buybacks while I wait of course. Remember, cash that is hoarded barely counts!

In a more uncertain macro environment that could actually significantly affect earnings, I am more skittish and take profits quicker and demand a cheaper valuation/more upside when I buy. For example in China in 2021 and 2022: inflation, potential Taiwan invasion, unravelling real estate market and their zero Covid strategy. Saved me from quite a bit of pain in Hong Kong stocks in the past 12 months.

My goal is to consistently hit easy singles and doubles while receiving sizable dividends. And discipline is key here, both by buying cheaply enough, selling on time and making enough effort to find alternatives that are cheaper.

With this approach I will occasionally miss out on big winners when there is an unexpected earnings beat. Or when a large capital flow from China bursts through to Hong Kong and creates market distortions (see 2015 for example). But often a rerating like that will not last, and are quite rare anyway. As soon as growth disappoints a bit, or there is negative news, that earnings multiple can go from 15-20x to 6-8x really fast. Even when growth is still positive.

So, Hong Kong stocks are certainly not for everyone. Disclosure is often pretty bad by Western standards. Minority shareholders are an afterthought for most CEO’s. Every hint of bad news can cause a large sell off. Merely the absence of good news can cause a slow decline in stock prices. And fraud is actually a significant risk (much less so if you follow the above checklist). But in return you get greatly discounted valuations, much more volatility you can take advantage of, very solid balance sheets and large (mostly) tax free dividends while you wait.

That said, my exposure to Hong Kong stocks is currently rather low. I don’t think they are that cheap currently with the added economic and political risks. Betting on a return to historical multiples is more risky now after what happened to Russian stocks. And in the US there is a lot of cheap stuff laying around right now. They are starting to look tempting though.