Investment Thesis On Why I’m Buying HSBC Stock

I’ve been buying into HSBC stocks for the past 2 months. I won’t disclose the amounts, but I bought equal amounts of shares for each month. I am considering buying more in the near future.

Gameplan Overview

Type of Play: Buy and Sell (Buy – valuation’s way too cheap due to recent news | Sell – HSBC isn’t a great company to hold forever)

Maximum Holding Period: 2 Years

Off the Cuff Analysis

I thought HSBC was a story worth looking into back in February when I was compiling a list of companies that provided products / services I couldn’t live without, and HSBC showed up [1]. The stock was price below tangible book, so my first instinct was it was undervalued.

As Joel Greenblatt mentioned in “The Little Book That Still Beats the Market”, the minimum return any investor should demand is 6% when 10 year US Treasury Yields are below 6%. At around 5.3% Dividend Yield during mid-Feb, HSBC stock was basically priced under the assumption that to get a 6% return, HSBC only needed to grow 0.7% in Dividends until perpetuity [2]. In my mind that seemed too conservative considering HSBC was growing its dividends in the past 5 years (2009-2013) at around 8% and has only cut dividends in its very long history of dividends thrice, once during the Dot Com bubble and twice during the 2008-2009 financial crisis, events that were extremely abnormal.

I think that was a flaw I would want to avoid in the future since such simple calculations and thinking was all it required for me to get into HSBC.

Then the poor interim results were released, Swiss Bank allegations started showing up, and a decrease in dividend growth (around 2% growth) was announced all around early March, and the stock price started to plummet. I started to panic since I didn’t do enough research, thought and calculations to give me the conviction to hold onto the stocks, so I decided to really dig deep in research before I came to the conclusion of whether to buy more, hold or sell.

Analyzing Short Term Pessimism

The 1st question I had to ask myself was, was the short term pessimism warranted? To answer that I had to dig deep into the three issues aforementioned.

For the poor interim results, the majority of the 17% decrease in profits from $22.6 billion to $18.7 billion could be explained by the $3.7 billion in fines paid out. Undoubtedly, I think the possibility of HSBC having to continue to pay out fines for other emerging legacy issues (eg. pre-Stuart Gulliver era issues) is very real in the short term future, but the frequency and amount of fines will decrease over time.

The reason being ties into why I feel that pessimism from the Swiss Bank allegations is too much. First of all, most of the issues HSBC currently faces that warrant fines were created prior to Stuart Gulliver’s (current CEO) era, so to think that these are the fault of the current senior management is ludicrous. Secondly, Stuart Gulliver has been extremely consistent, transparent and swift about disclosing and dealing with the legacy and new problems since taking over, selling 77 businesses, reducing headcount from 310,000 to 257,000, de-layering the organization structure, reducing HSBC Swiss private bank’s assets and number of clients down 70% way before allegations came out and even cutting his own annual bonus when HSBC was found to have paid ~400M pounds due to the currency rigging scandal under his reign. If the issues were the current senior management’s fault and future issues aren’t actively prevented from happening, then the pessimism is warranted.

Also the fact that Stuart Gulliver is questioned as incompetent to run HSBC by UK MPs is completely ridiculous. If Stuart Gulliver is “unfit” to lead HSBC just because he opened a Swiss account to avoid HSBC non-Swiss staff to pry into how much he earned and hold it under a Panama company to stop HSBC Swiss staff to peek into his Swiss account, then I don’t know who else is competent in ability and integrity to lead HSBC. The man paid all his taxes, and as one of HSBC’s top earners, can’t he enjoy some financial privacy?

As for potential low dividend growth in the short term, it is only a serious concern if I bought HSBC stock with very little to no margin of safety. Buying in at $72.7 HKD / share (~5.3% Dividend Yield) meant that dividends only needed to increase by 0.7% / year until perpetuity to get me my 6% return, which is still very do-able even when HSBC only grew its dividends by 2% from 2013 to 2014.

Analyzing Long Term Staying Power

After thinking through the short term pessimism, the next question I have to ask is, what are the factors that will allow HSBC to keep growing dividends by at least 0.7% until perpetuity? Using Charlie Munger’s Four Filters, I broke down HSBC as follows:

1. Understand the Business & 2. Sustainable Competitive Advantages

HSBC is run under 4 divisions, namely Retail Banking & Wealth Management, Commercial Banking, Global Banking and Markets and Global Private Banking. The greatest advantage that HSBC has over its nearest competitors is where it is situated geographically (namely Asia and Developed Markets), as its closest competitors in the region (Standard Chartered and Citibank) are nowhere near in scale in terms of network in Asia and between Asia and Developed Markets.

The second great advantage that HSBC has over its competitors is its synergy between divisions, where customers can constantly be cross-sold across different divisions’ products or services seamlessly under one platform. As a HSBC customer for 15 years (since Year 2 in Primary), I can testify that people might complain about services and all the advertisements, but people nevertheless stay in the HSBC system for convenience, where people are willing to pay the extra fees just to be able to do savings, checkings, credit card, investments, mortgages, loans, insurances across different countries all in one platform.

Which leads to a huge looming threat to HSBC that must be mentioned. If HSBC doesn’t solve its image of being horrible at service, sooner or later the synergy between divisions will break down if people start leaving HSBC for better alternatives. People are staying because the alternatives suck even more, not because people are really happy with HSBC services.
3. Able and Trustworthy management

I have no doubt about the integrity of Stuart Gulliver and Douglas Flint (current Chairman). If you’ve read the what they say in annual reports and interviews since taking over in 2011 and compare it to what they have done, there is absolutely consistency with doing what they said they were planning to do. Also a fact that many people seem to overlook is the fact that HSBC is conservatively financed, always exceeding Basel requirements in terms of Tier 1 Capital ratios. I really like conservatively financed companies.

4. Bargain Price and Margin of Safety

As mentioned earlier, I demand at least 6% returns when 10 year US Treasury Yields are less than 6%. Being priced at 5.3% dividend yield meant that HSBC only needs to grow 0.7% dividends until perpetuity to get me my 6% return from dividends alone.

Considering all of the four factors aforementioned, I bought more stocks mid-March at $66.1 HKD / share (~5.8% dividend yield) since the implied dividend growth of 0.2% until perpetuity seemed ridiculously low.

Possibilities of Returns

So what are my possibilities of returns in the future? If I only take dividends into consideration (eg. never selling), then you can split my possible situations into a spectrum of pessimism and optimism, which could be something like this:

Possibilities of return of all my HSBC stocks (Dividends Only)
– Cut 50% and stagnant afterwards = 2.775% return until perpetuity (Extremely Pessimistic)
– No dividend growth and no cut = 5.55% return until perpetuity (Pessimistic)
– 4% growth (half of 5 year average growth) = 9.55% return until perpetuity (Optimistic)
– 8% growth (5 year average growth) = 13.55% return until perpetuity (Extremely Optimistic)

When to Sell

I am going to sell my HSBC stocks within 2 years. As mentioned earlier, HSBC has cut dividends before when times were rough and its poor reputation in services and price means that HSBC still possesses huge market shares because its competition sucks instead of because HSBC is great.

If HSBC can become better in the latter section before it hits my selling price, I might consider, but there are no signs of that as of now.

And the prospect of being able to sell within 2 years excites me, because the fact that not only do I have a good deal through dividends alone (since I don’t have to pay dividend taxes on UK stocks), I can also potentially earn more through capital gains. So when do I sell to capitalize on such capital gains?:

When to sell?
– When 10 year US Bonds return > target return (target return is 6% for the HSBC stocks)
– When current dividend yield + half of 5 year dividend growth is less than target return while better investment opportunity arises (want to make sure I don’t hold onto stocks for too long by waiting for stock price to rise to needing 5 year dividend growth instead of half of that to get my target return)
– When holding period of 2 years is up

How to do Better
So as you can read, I did make a mistake of investing initially with only off the cuff analysis. I was lucky that I went in with a large margin of safety and that further research and analysis proved me right, but I can’t count on such luck in the future.

Also in terms of execution, I would’ve probably bought less stocks per purchase in the future. Doing this allows me to dollar cost average into more months as the stock price keeps plummeting. Currently I’ve tied up significant capital already in HSBC stocks, and that’s 2 months. This means I might not be able to get even cheaper bargains if HSBC stock prices continue to slide (which is very likely).

[Footnotes]

[1] The reason why I can’t live without HSBC is because as someone who lives in Hong Kong and has Canadian nationality, the ATM and retail bank branch network of HSBC is unparalleled in Hong Kong, while HSBC’s retail bank presence in Canada means I can easily transfer funds between the two places.

[2] I used a Dividend Growth formula, which is Fair Price = Dividend / (Discount Rate – Growth Rate). Discount Rate is another way of saying what return I demand from my investment

[Disclosure]

I am long HSBC

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

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