Don’t invest in HSBC plc without taking a view on China

hsbcEarlier this month, I said there was a strong case for buying HSBC Holdings (LSE: HSBA) (NYSE: HBC.US) while it is still cheap. It is up more than 5% since then, but I still think there is a strong case for investing in HSBC. Earnings per share are forecast to rise 9% this year and 11% in 2015, which would lift the yield to a forecast 5.7%.

But there is one thing you need to consider before parting with your pounds: China.

Beware the big black swan

The Chinese economy looks like the ultimate black swan event. It could suddenly swim into view, scaring the bejeezers out of everybody. There is plenty to fear, with the world’s second-biggest economy desperately trying to contain a rampant credit and property bubble.

The question is how much you should take these “known unknowns” into account when deciding whether to trade an individual stock. 

Money worries  

Here is some Chinese arithmetic for you. In the last five years, credit has soared from 150% of GDP to over 200%, as the government battles to keep the GDP growth engine on the rails. The soaring supply of money has driven down capital efficiency, according to Zhang Monan from the China Foundation, and driven up debt ratios at governments, banks and businesses. The People’s Bank of China has been trying to clean up its toxic assets and promote bank deleveraging, but risks a severe liquidity squeeze. To make matters worse, China’s “demographic dividend” looks like turning into a demographic disaster, as the one-child policy leaves a shrinking number of workers to support an ageing population.

My personal view is that China is on a similar trajectory to the West in the run-up to the financial crisis. You also need to take a view on China, if you’re investing in HSBC. Judged by assets and branch network, HSBC is the biggest overseas bank in China. It was also the first foreign bank to join the Shanghai futures exchange. Last year, its profits in China rose 12% to $626 million. 

Shadow play

Although HSBC has ditched some Chinese assets in recent years, notably its 15.6% interest in Ping An Insurance and 8% stake in the Bank of Shanghai, it still owns 19% of China’s fifth-largest bank, the Bank of Communications, and 49% of HSBC Jintrust Fund Management. If the crisis catches fire, HSBC could suffer a Chinese burn. Some analysts even claim to watch the HSBC share price to spot signs of stress in the Chinese shadow banking system.

After three years of flat growth, HSBC does look tempting. You can buy it on a forecast price/earnings ratio of 11.9 times earnings. It is also a huge globally-diversified operation, rather than a pure play on China. And in any case, that hard landing may be averted. But if you’re tempted, make sure you know what you are getting.

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Harvey Jones doesn't own shares in any company mentioned in this article