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How Will HSBC Holdings Plc Fare In 2014?

For most shares in the FTSE 100, 2013 was a good year and investors have likely enjoyed capital gains and rising dividend income.

That makes me nervous about investing for 2014 and beyond, and I’m going to work hard to adhere to the first tenet of money management: preserve capital.

To help me avoid losses whilst pursuing gains, I’m examining companies from three important angles:

  • Prospects;
  • Risks;
  • Valuation.

Today, I’m looking at banking and financial services company HSBC Holdings (LSE: HSBA) (NYSE: HSBC.US).

Track record

With the shares at 673p, HSBC’s market cap. is £126,687 million.

This table summarises the firm’s recent financial record:

Year to December 2008 2009 2010 2011 2012
Revenue ($m) 88,571 78,631 80,014 83,461 82,545
Net cash from operations ($m) 30,420 6,898 55,742 79,762 (9,156)
Adjusted earnings per share (cents) 136.56 34 73 92 74
Dividend per share (cents) 64 34 36 41 45

1) Prospects

With the three-quarter results released in the autumn, HSBC reported underlying pre-tax profit up 34% on the year-ago figure. That good result seems to indicate something of a return to business-as-usual for banks like HSBC as the macro-economic environment stabilises.

However, more than half that profit came from what the firm describes as its home markets of the UK and Hong Kong. According to the CEO, the rest of world still presents a mixed macro-economic picture, so it seems that there’s potential for further recovery in HSBC’s business yet.

Like most companies, HSBC has been sharpening up its act since the financial crisis, pruning lacklustre areas of its business and driving out unnecessary costs. One example is the ongoing remodelling of operations in the US, which HSBC hopes will improve profitability and growth there. Overall, the firm reckons that its actions on company-wide restructuring and simplification since 2011 are now on track to save $4.5 billion annually.

So what’s in store for HSBC investors from here? To me, it looks like a gradual trading improvement that will run in lock step with the strength of the general world economy. HSBC’s global reach and emphasis on emerging markets is reassuring, and many will judge the success of an investment in HSBC by the strength of the dividend payout. Indeed, the firm seems committed to driving forward its progressive dividend policy.

2) Risks

However, remember banks are cyclical and P/E compression could result in a lacklustre share-price performance taking the shine of that dividend income as the macro-cycle rolls out.

The CEO refers to continuing regulatory uncertainty on the horizon. As far as banks are concerned, increasing regulatory demands can crimp business development, as the firm has to channel funds to the balance sheet rather than to growth projects. HSBC’s core tier 1 ratio now stands at about 13.3%, up from about 7% in 2008. That level of difference changes the terms under which banks like HSBC do business. If the regulators demand higher levels for the tier 1 ratio, or if standards increase in other areas of compliance, more capital resources will need to be recycled, which could stymie growth.

3) Valuation

HSBC is trading at around 1.1 times net asset value further suggesting ‘normal’ trading times ahead: it’s when the outlook is dire that we see discounts to net-asset value with the banks.

Consensus forward-earnings estimates have earnings covering 2015’s dividend around 1.8 times. The forward yield is about 5.7%, which looks attractive. However, the forward P/E ratio is running at 9.7, which is worth keeping an eye on because there’s plenty of potential for that rating to compress with the unfolding macro-economic cycle. Maybe the level of increasing earnings will overcome any P/E contraction effect, leading to decent investor returns from here.

What now?

As and investment proposition, banks scare me right now. I can see how the yield is attractive, but the inherent cyclicality of the industry brings too many risks for my liking.

Dividend investing is not always as simple as it might appear. That’s why the Fool has released a special report featuring 5 Golden Rules for Building a Dividend Portfolio. The rules can help avoid some of the pitfalls waiting to trap dividend-hunting investors.

If HSBC Holdings has popped up on your dividend filters for further research, or if you’re thinking of taking the plunge with other high-yielding shares, I recommend reading this report first. To get your copy, click here.

> Kevin does not hold shares in HSBC Holdings.