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Is HSBC Holdings plc A Promising Capital-Growth Investment?

If banking and financial services company HSBC Holdings’ (LSE: HSBA) (NYSE: HSBC.US) share price hasn’t made any meaningful progress over the last 15 years, which it hasn’t, why should investors expect a different outcome over the next 15 years, which many probably don’t!

That’s a good question. Along with the other London-listed banking companies, HSBC looks like a rubbish bet for capital growth. Banks are for playing the ups and downs of macro-economic cycles and nothing more. If you are thinking of diversifying your portfolio with a bank like HSBC, don’t. What’s the point? I can’t think of a worse risk/reward proposition than expecting an out-and out cyclical company, such as HSBC Holdings, to do you proud on capital growth, or even total returns including the dividend, over the long haul.

Emerging-market strength

The big temptation must be HSBC’s dominant presence in emerging markets. Around 70% of 2013’s profit before tax came from Hong Kong and the rest of the Asia Pacific region. Asia is HSBC’s home ground and a more experienced overseas operator is hard to find. But experience doesn’t net out as forward growth prospects. HSBC is still handicapped by its operating industry. Banks just don’t make decent growth investments.

With all the other industry sectors available, all with companies forging ahead in up-and-coming regions of the world, why not pick a proper business to back? Banks are not ‘proper’ businesses in my view, they are proper-business facilitators. Banks don’t have a product, or specialist intellectual property, or a must-have service that no-one else can provide, or assets that grow to build value, all banks do is provide the funds that other businesses need to prosper and the means to handle their money. For that mundane service, the banks skim a fee and use any profits to bet on the financial markets. To make it all worthwhile in the short term, banks gear up to heady proportions.

That’s a business model that’s super glued to macro-economic cycles. If there’s a dip in worldwide business performance, the banks feel it most keenly, and wilt just as a leech would finding itself on a lifeless carcass.

HSBCHeadwinds

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.

City analysts expect HSBC to grow its earnings by around 8% this year and 9% the year after. Meanwhile, the forward P/E rating sits at just under 11 for 2015 and there’s a dividend yield of 5.3% predicted for that year. That sounds so tempting, right. Forget it. Valuing banks is tricky and the indicators tend to work back to front.

Banks are for trading; they don’t make good long-term investments. It can be a good idea to buy banks when the P/E rating is high, such as in 2009 when earnings were down. Then we might catch the up leg of the macro-economic cycle and a rocketing share price. But when earnings are high, when economic cycles are getting towards their peak, banks tend to trade on low P/E ratings and high dividend yields. Then’s a good time to sell, to avoid the share-price plunge that often follows peak earnings. That’s not a perfect investment-timing model but it’s better than none at all, and it’s a darn good start if you are considering banks as an investment.

What now?

So where are we now? It’s hard to say but, generally, gradual P/E compression seems likely as we travel along the macro-economic cycle. The market will be anticipating the next earnings peak, the one before the next earnings’ decline. Such a mechanism of valuation drag seems destined to keep any investor gains modest at best over the long haul. Is it a good time to invest in banks such as HSBC now? It doesn’t seem like it to me. Is it a good time to invest in banks such as HSBC for the long haul, ever? It doesn’t seem like it to me…

Rather than invest in banks, like HSBC Holdings, 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.

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 Godbold has no position in any shares mentioned. The Motley Fool has no position in any of the shares mentioned.