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HSBC is deep-value

HSBC shares have been an unprofitable investment in the past year, falling from 780 pence on the London Stock Exchange to just below 600 pence now.

This fall was due to the market’s China credit/emerging market angst, loan losses in Mexico/Brazil, regulatory capital issues and accounting adjustment loss on its Bank of Communications (China) 19 per cent stake. Revenue growth in 2013 was a mere three per cent and returns in the US were still weighed down by legacy issues in consumer credit. Stuart Gulliver’s corporate restructuring has slashed payrolls and assets at the fabled but humbled world’s local bank. HSBC Global Market’s debt portfolio was gutted by higher US interest rates and losses in emerging market currencies. HSBC was also forced to take losses on loans to Mexican homebuilders. 2013 was an “annus horribilis” for HSBC while French, Dutch and American banks (BNP, SocGen, ING, JPMorgan, Citi, Bank Am) were such phenomenal money-makers on the stock exchanges.

However, in homage to Graham and Dodd, I view HSBC as a deep-value investor (given that momentum investing in Honkers and Shakers is a pipe dream). The bank’s value metrics are compelling enough. HSBC now trades at nine times forward earnings and a 6.4 per cent dividend yield. HSBC dividend yield for 2014 is 5.4 per cent, so I am paid to “wait” for financial markets (or the HSBC board and regulators) to unlock value. After all, at 600 pence, my valuation paradigm tells me I am buying one of the world’s pedigreed international money-centre banks at all of one times forward book value. The bank will earn a respectable 10 per cent return on equity and has a Basle Tier One capital ratio that is a stellar 14.6 per cent. If China’s credit woes or Russian sanctions escalate, the impact on HSBC will be immediate. So can HSBC fall to 560 pence in London? Absolutely yes.

HSBC is still in the early innings of an epic balance sheet derisking, after the disaster with Household International and the succession of scandals in various bank subsidiaries. HSBC is not exactly the darling de jour on Wall Street, since “growth markets” (submerging Brics et al, etc) contributed 56 per cent of the group’s revenue. So I do not expect any immediate revaluation, the reason I like to sell 0.6 delta in the money put option whenever volatility spikes in the option markets. I would also not hold my breath on any capital return bonanza at HSBC. I was distressed to learn that HSBC Private Bank profits slumped 81 per cent after the draconian regulatory probes and outflows from its Swiss private banking business, since this was once a $1 billion a year pretax profit business in its golden age after the Safra Republic Bank acquisition. HSBC saw almost $30 billion in client assets outflows from Switzerland, sale of private banking businesses in Panama, Luxemburg and Kazakhstan write downs in Monaco. The Swiss private bank was badly hit by the reputation risk and financial damage that resulted from the client data by a software engineer in Geneva three years ago. This led to tax witchhunts in Britain, France, Spain and Germany.

HSBC has reduced its global footprint, particularly in the US consumer loan and credit card business. I can also see exits in many crowded retail banking markets worldwide. Cost control is essential. Return on equity targets at 12 to 15 per cent are unrealistic for now.

HSBC needs to take dramatic strategic decisions to reengineer its post-crisis business model and continue slashing costs, down almost $5 billion in the past three years. It must invest in its core Hong Kong/Asia franchise and possibly exit overcrowded “utility” areas, such as High Street banking in the Britannic sceptered isle. It is entirely possible that earnings could grow eight per cent even with mediocre three per cent revenue growth in 2014. In a world where Lloyds and RBS yield nada, the HSBC dividend should attract Britain’s pension fund managers — and pensioners! The HSBC chart looks predictably awful, with an ugly downtrend in place. However, I believe the ghost of Benjamin Graham now tells me to make a long hard look at the shares below 600 pence in London.