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Why I think HSBC’s fat dividend is unattractive and where I’d invest instead

I gave up a long time ago expecting the big London-listed banking stocks to behave like the shares of other trading companies. When it came to the banks, out the window went everything I’d learned about how share prices value their underlying companies.

A shrinking valuation

Clinging to traditional valuation techniques can deliver such puzzling outcomes. Banks such as HSBC Holdings  (LSE: HSBA) have looked under-valued for a long time, despite their profits generally rising each year. We can hunt around for all manner of reasons that might explain the anomaly, but nothing seems to work. Bank shares seem to go down when they ‘should’ go up, and up when they ‘should’ go down. But the background to all those undulations in share prices is, in many cases, a longer-term downtrend and a maddeningly low valuation, even when business seems to be booming!

I think it all comes down to the cyclicality inherent the banking businesses. I see them as cyclical beasts to the very core, and so does the market, it seems. That’s why I think the valuation of HSBC has been falling. We’re in a fairly mature stage of the general economic cycle and the firm’s earnings have been elevated for some time. The only ‘weapon’ the stock market has to counter a downturn in the cycle is valuation. So I reckon it marks down the valuation of HSBC all the more the longer big profits persist, in anticipation of earnings plunging down the line.

No one knows when the next downturn will arrive, of course. But I’m not expecting an upwards valuation rerating for HSBC and I think valuation-compression will likely keep the upside capped for investors’ ongoing total returns from the company. Yet the downside risk is huge. When and if a downturn arrives, the share price will likely plunge along with earnings and the dividend, despite the low-looking valuation now. Some shares dropped more than 90% the last time big banking shares crashed around 2008.

A good test of business health

But I reckon a good test of the underlying health of any business is to look at the dividend record. Company directors don’t raise a dividend every year if the outlook seems a little murky to them. And if they reduce the payment, look out below because the share price is probably going down fast. HSBC’s dividend has been essentially flat since 2013 and I think that speaks volumes. Taken with the low valuation, I think the stagnant dividend is a warning. My guess is that neither the share price or the dividend will move much higher and could both move rapidly down from where they are now.

At this stage in the cycle, I see HSBC and the other big banks as poor choices for a long-term holding strategy. Instead of taking on all the single-company and cyclical risk with HSBC today, this is one of those times when I’d rather spread my risk by investing in a low-cost, passive index tracker that follows the fortunes of the FTSE 100. I reckon a tracker that automatically reinvests the dividends will likely outpace the total returns from HSBC over the long haul.

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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.