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Beware the siren call of the HSBC share price

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I invested in HSBC Holdings  (LSE: HSBA) once, around 2005. Back then I thought the banking firm had a fair valuation, a decent dividend, and oodles of potential to expand. I was convinced that by now the share price would be well up from the level it was when I bought the shares.

Piggy-backing the economic activity of others

Today the HSBC share price stands close to 720p. In 2005, 13 years ago, the shares were trading around 750p. That’s definitely not the investing outcome I was looking for back then. The journey for shareholders hanging on has been ‘eventful’, with the price going as high as 870p during November 2006 and as low as 360p in March 2009. Since then, the stock has undulated up and down between those two parameters without breaching either limit again. Such is the ‘lot’ of those holding out-and-out cyclical stocks like HSBC Holdings.

The problem is not just that cyclical businesses experience famine or feast profits depending on general macroeconomic conditions, it’s also that the stock market as a whole ‘knows’ it. Banks like HSBC are cyclical to their very core. There isn’t much added-value to the service they offer customers that could insulate the banks from macroeconomic wobbles. In their basic banking activities, HSBC and the others piggy-back the economic activity of their business and personal customers, skimming a profit from their endeavours by facilitating the management and use of money.

To prosper, HSBC requires its customers to thrive and if they are hit by a downturn in the economy its profits and cash flow will fall too. You can see from the share-price chart that plunges are common. If profits fall, or if the stock market thinks profits will fall, the shares are marked down. In cases where banks cut their dividends, we can see share-price falls of 50% or more. In the wake of last decade’s credit-crunch, some banks’ shares went down as much as 95%.

I don’t think the bank is as attractive as it seems

But I reckon the banks can be confusing stocks for investors. Looking at HSBC right now, at first glance its valuation looks attractive. Meanwhile, profits have been pretty good for a few years. If earnings go up from here, many believe the stock will rise, but I’m not so sure it will.

I reckon the stock market as a whole ‘knows’ all about the cyclical risks that HSBC and the other banks face and will be cautious when earnings rise, particularly after a long period of good trading, such as we’ve seen over the last few years. As the up-leg of the macroeconomic cycle unfolds and HSBC’s earnings rise, I think the stock market will crimp the firm’s valuation. The higher the profits go, the lower I reckon the valuation will go. Why? because the market has seen it all before and knows that the next cyclical plunge in profits will arrive at some point down the line and a lower valuation aims to discount for that. Such valuation-compression probably won’t work very well. The share price will still plunge when HSBC’s earnings next fall. So, I see limited upside potential and lots of downside risks with HSBC now, both for the share price and for the dividend.

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Kevin Godbold has no position in any of the shares mentioned. The Motley Fool UK has recommended HSBC Holdings. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.