Undervalued Dividend Gem Set for Growth - HSBC

Business Overview & Strategy HSBC was founded in 1865 as the Hong Kong and Shanghai Banking Corporation (“HSBC”) and ranked as the sixth-largest bank in the world based on total assets (Ali, 2020). HSBC is listed primarily at London and Hong Kong exchanges, with a secondary listing in New York as American Depository Receipt [ADR]. The biggest revenue contributor is Asia (50%) especially Hong Kong and mainland China, followed by Europe (28%), North America (11%), Middle East & North Africa (6%) and Latin America (5%). HSBC operates in four operating segments, namely Retail Banking and Wealth Management (43%), Global Banking and Markets (28%), Commercial Banking (26%), and Global Private Banking (3%).  HSBC aims to leverage its large international exposure to target a faster growing and higher returning market, particularly Asia while reducing European exposure. The FY2020 balance sheet makes it clear as to why HSBC takes the step; Asia contributed 146% of net profit with 47.7% gross margin, whereas Europe contributed a net loss of -48% as operating expenses exceeding the revenue. Further, HSBC also aims to maintain its position as a global leader in cross-border trade, payment, and money management by leveraging its operations in over 64 countries and a strong brand name. Investment Thesis HSBC global scale operations and strong presence in Asia with over 155 years of history serve as a unique and sustainable competitive moat that most other banks do not have. It is particularly attractive as Asia is expected to have a trade flow growth rate of CAGR 8.6% from 2020 until 2025, higher than the rest of the world at a 6.9% growth rate (IHS Markit, 2020). In the past 10 years, HSBC has been focusing its effort to expand to the Asian market by launching its "Asian Pivot" strategy and it has shown positive results as Asia’s region as a percentage of revenue double from 2010 to 2020. HSBC still take proactive measure in its penetration effort in Asia as it announced the plan to invest up to $6b grow in the coming years (Clarke, 2020). HSBC has a track record of safety and strong performance, supported by industry tailwinds. In the past 10 years of operations, the deposits have always exceeded loans, which is a good liquidity indicator especially given that HSBC’s large operations in the retail and commercial lending business. On top of that, HSBC also has a significantly higher net interest margin [NIM] than other large-cap European bank peers in the last 10 years, albeit decreasing lately due to low interest rate environment. Net interest margin is one of the banks’ main profitability measures, which is calculated as the difference between interest earned from giving out loans and interest paid to customer deposits. Hence, the steepening yield curve and higher interest rate expectation in the coming years serve as tailwinds to the banking industry globally, including HSBC, as it takes away the margin pressure and will raise profitability.  For note, the current low rate environment is not necessarily a bad thing for HSBC as well as it incentivizes people to take more loans and mortgages which essentially drives up the revenue volume. Moreover, it is an excellent environment for businesses to raise more capital, thus strengthen the Capital Markets segment of operation. HSBC is currently trading at a historic low valuation, serving as an attractive entry point given high potential upside as stated in previous paragraphs. Currently, HSBC is trading at a discount of 0.68x relative to its European peers of 0.72x and it is far cheaper than Canadian banks with a 2.04x P/B ratio. HSBC will likely trade on the premium (10-year historical P/B average was 1x vs 0.9x European peers) given HSBC’s large exposure to the highly profitable Asian market. HSBC also has an impressive 10-year average dividend yield of 5.2%, which is higher than both European and Canadian peers (~4%). For Canadian investors, HSBC would be a great addition for portfolio diversification, particularly to gain some exposure to the Asian and European markets, and to avoid home bias. The beta of 0.92 makes the stock relatively stable and requires minimal active management while offering an attractive dividend yield.  Looking as to why HSBC has been performing relatively poorly in the last two years, it was mainly driven by volatile global political situations, specifically due to Brexit and US-China Trade War in 2019, followed by the pandemic in 2020. HSBC's worsening performance, therefore, is caused by external shocks, while its fundamentals remain strong especially if we consider the 23% dividend return in the past five years and decent deposits growth (HSBC Holdings, 2021). Outlook Looking ahead in the post-pandemic world, I expect HSBC to start showing price appreciation as the economic recovery in Asia starts picking up in the next few quarters. Massive reduction in PCL will also boost the earnings in the next few quarters, similar to what already happened to banks in North America. The steepening yield curve and the rising interest rate would also improve HSBC's profitability and HSBC is likely to benefit more than other global banks as they have more exposure to the high-growth Asian markets and moving away from the European markets. Over the long-term, the price is likely to stabilize at a historical P/B ratio of about ~1x, but investors will highly benefit from the above-average dividend yield that would die up the total returns.  Regarding the political risks, the Brexit and US-China Trade War are expected to be stabilized as countries are focusing their efforts on stimulating the economy to offset the impact of the COVID-19 pandemic (Friis & Pothalingam, 2021).  Regarding US-China Trade War, it is likely to be calmer with the new Biden administration. Overall, the outlook on political stability is positive for HSBC in the post-pandemic world relative to the last two years. References Ali, Z. (2020, April 07). The world's 100 largest Banks, 2020. Retrieved April 05, 2021, from https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/the-world-s-100-largest-banks-2020-57854079 Clarke, P. (2021, February 23). HSBC plans $6bn in Asia investments as profits slump by 34%. Retrieved April 05, 2021, from https://www.fnlondon.com/articles/hsbc-plans-6bn-in-asia-investments-as-profits-slump-by-34-20210223?adobe_mc=MCMID%3D57244812709731614374459840912138525497%7CMCORGID%3DCB68E4BA55144CAA0A4C98A5%2540AdobeOrg%7CTS%3D1617507920 Friis, P. B., & Pothalingam, K. (2021, January 20). Beyond Brexit: Outlook and risks for the U.K. Economy. Retrieved April 05, 2021, from https://blog.pimco.com/en/2021/01/beyond-brexit-outlook-and-risks-for-the-uk-economy HSBC Holdings plc. (2021). Total share return. Retrieved April 7, 2021, from https://www.hsbc.com/investors/shareholder-information/total-share-return IHS Markit. (2020). Global Economic Forecasts Analysis and Data World Economic. Retrieved April 05, 2021, from https://ihsmarkit.com/products/global-economic-forecasts-analysis-and-data-world-economic-service.html