Management at HSBC (LSE:HSBA) recently changed a key policy target. While the bank previously targeted a return on average tangible equity of 10%–12% by next year, management is now targeting “a return on tangible equity at or above 10% over the medium term”. Given how important the target is, here’s what I think the change means for the HSBC share price.
Change in targets
On one hand, I reckon the change in the target isn’t good. If HSBC doesn’t make as much return on average tangible equity, it won’t make as much profits, all else equal. If the bank doesn’t make as much profits, it won’t have as much money to buy back stock or to pay dividends.
On the other hand, however, I realize that HSBC cut its goal due to an unforeseen circumstance. Due to the pandemic, central governments around the world have lowered interest rates substantially. As a result of the ultra-low interest rate environment, HSBC is making considerably less in interest rate-related income. In the bank’s fourth-quarter transcript, CEO Noel Quinn quantified the challenge. He said the bank “lost around $5.3bn of net interest income” due to lower interest rates. That headwind has also translated into a more than 2 percentage point decrease in return on tangible equity.
Given the ultra low interest rate environment headwind, realizing a higher return on average tangible equity is considerably harder even if management has cut a lot of costs. As a result, I think management being practical is a good thing. If management weren’t practical, they might do riskier things to achieve their target.
Were HSBC to make riskier loans to increase its return on tangible equity, for instance, the bank might achieve its previous higher target but ultimately not add as much value in the long term. If HSBC were to make a bad M&A deal to achieve a higher return on tangible equity, it would also not be a good thing. One of the reasons why the HSBC share price hasn’t done well since 2000 is due to bad M&A deals that have destroyed value.
The HSBC share price: what I’d do
I reckon HSBC has its fair share of risks. If Covid-19 variants prolong the pandemic, the expected economic recovery might not be as strong and the HSBC share price could disappoint. Although fintech in less developed parts of the world offers a potential growth opportunity, it could also disrupt HSBC’s business. If management doesn’t deliver the results that investors expect, the stock might not do well.
In the long run, however, I like the stock at the current HSBC share price given its Asia business and its valuation. The bank trades at a price-to-book ratio of 0.73, which I think could increase if management grows profits and returns more capital back to shareholders over the coming years. I also reckon the lower target return on tangible equity could also mean potentially lower expectations. With lower expectations comes greater potential to beat them.
