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Should I Invest In HSBC Holdings Now?

Banks are strange beasts. You’d think with all the positive macro-economic news blowing about that business would be flying. Yet HSBC Holdings (LSE: HSBA) (NYSE: HSBC.US) updated the market this month saying underlying earnings are down 13% for the first quarter of the year.

Emerging-market strength

Of course, HSBC operates worldwide and not just in Britain. In fact, around 70% of 2013’s profit before tax came from Hong Kong and the rest of the Asia Pacific region, making the firm something of a play on emerging markets like China. Asia is HSBC’s home turf. If you’re looking for experience and a track record of success in an emerging-market investment, HSBC cuts the mustard.

Why banking?

Why, indeed. I can understand investors seeking diversification in their investments, but there can’t be many investors left over the age of, say, twenty who still believe that investing in banks is a safe option. The general backdrop to the banking sector is that profits rise and fall along with macro-economic cycles. Legendary American investor Peter Lynch classified banks as Cyclicals. Up and down go economic cycles and up and down go the share prices, P/E ratings and dividend payments of the public limited banking companies.

If you’re thinking of a long-term investment in a bank like HSBC, forget it, I’d say. Bank shares are a way to play the macro-economic cycle, and nothing more. If you don’t believe me, look at HSBC’s longer-term share price chart. The share price is roughly just where it was around fifteen years ago. Admittedly, there are other trends at play here too, such as the rising affluence of populations in growing markets such as Asia where the firm is dominant. But investors must weigh the growth expected in emerging markets such as China against the cyclical behaviour of the shares.

Headwinds

HSBC’s CEO reckons that customer activity is muted, even though the firm is winning market share in some areas. On top of that, regulatory and governance requirements continue to rise increasing the firm’s costs. The banking industry looks set to remain in the spotlight for some time, and it seems unlikely that a return to fast-and-loose speculation will be boosting earnings across the sector any time soon.

Valuation

HSBC’s forward dividend yield is running at about 5.5% for 2015 and at a share price of 615p, the forward P/E is just over ten. Forecasters expect earnings to grow at about 10% that year. So, on the surface, the valuation looks attractive.

However, valuing banks is tricky. The indicators tend to work back to front, and it’s often a good idea to buy banks when the P/E rating is high, such as in 2009 when earnings were down. That way you might catch the up leg of the macro-economic cycle and a rocketing share price.

When earnings are high, when economic cycles are getting towards their peak, banks tend to trade on low P/E ratings. Then’s a good time to sell, to avoid the share-price plunge that often follows peak earnings. So where are we now? It’s hard to say but, generally, gradual P/E compression as we travel along the macro-economic cycle seems likely, in anticipation of the next peak. Is it a good time to invest in banks such as HSBC? It doesn’t seem like it to me.

What now?

Rather than invest in banks I’m looking for businesses that can grow. I want to understand a firm’s business model, see clearly how its operations are performing, and feel able to value it with a reasonable degree confidence. All things that banks deny me.

I'm keen on a share idea for capital gains from one of the Motley Fool's top small-cap investors. His diligent research has uncovered what looks like one of the best growth shares for 2014.

Sometimes growth comes from within when a company reinvents itself and pursues a different line of operations. When that happens, valuations can remain modest, as investors are slow to catch on to the new growth potential. That's what seems to have happened with this gem. A strong recovery in profits followed restructuring and the directors predict double-digit margins driving a profits surge in the years to come.

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Kevin does not hold shares in HSBC Holdings.