Is the Hong Kong market a bargain or losing its edge?

With the Hang Seng Index trading at its cheapest valuation in 10 years – close to the valuations of Russia’s and Pakistan’s markets – it’s an important question.

So what’s wrong? A couple of things…

Crony Capitalism: The China-controlled government is blocking any political reforms. As a result, crony capitalism is steadily rising, with Hong Kong at the top position of a “crony index” put together by The Economist. The cost of living in terms of housing costs and food is soaring. Even the cost of groceries is 30% higher than in New York.

Manufacturing: A key pillar of the economy, manufacturing has almost completely migrated to other low-cost countries. And shipping, while still vibrant, is losing market share to lower-cost ports like Shanghai.

Now, given my experience with Hong Kong politics, the economy, and business over three decades, I must say these trends are a little concerning.

With China seemingly trying to marginalize Hong Kong in favor of developing Shanghai into the region’s leading financial center, you might think the “Pearl of the Orient” is losing its luster as the commercial and cultural gateway to Asia and that you should avoid investing in Hong Kong companies.

I wouldn’t bet on it for several reasons:

1. Hong Kong still has a well-earned reputation for being one of the world’s most open economies. That’s why 1,389 multinational companies base their regional headquarters there, despite the fact that rents are double that of Shanghai. 
   
   In fact, according to the closely followed Heritage/Wall Street Journal 2015 Index of Economic Freedom, Hong Kong has remained at the top of the heap, followed by Singapore, New Zealand, Australia, and Switzerland. The United States ranked No. 12, while China is in the “mostly unfree” category at No. 139.
    
2. In terms of growth and profitability, it matters a lot more where you do business rather than where your business is based. In this regard, Hong Kong companies have deep tentacles that reach into China and the dynamic Southeast Asian region.

The bottom line is that with the Hong Kong market trading at half the valuations of China, it’s a genuine buying opportunity.

A Tale of Two Conglomerates

If you wanted to take the shotgun approach to investing in Hong Kong, there’s the iShares MSCI Hong Kong ETF (EWH).

While this gives you exposure to a wide variety of large and mid-sized companies, I suggest zeroing in on two leading consumer conglomerates with a long history in Hong Kong, instead.

The first is Jardine Matheson Holdings Ltd. (JMHLY).

Founded in 1832, the company is incorporated in Bermuda but headquartered in Hong Kong. About 40% of its profits are from greater China with 47% from Southeast Asia.

Here’s just a sampling of its diversified businesses:

• Jardine owns the leading supermarket and health and beauty chain, the 7-Eleven convenience store chain, and IKEA furniture stores, and it operates the Starbucks franchise in Hong Kong.

• It also owns large amounts of prime commercial property in the heart of Central Hong Kong, where its buildings form an interlinked network of offices and retail space.

• The company currently owns or has substantial interests in 15 hotels worldwide, including the Mandarin Oriental, as well as car dealerships in Hong Kong, Macau, China, and the U.K.

Jardine Matheson stock trades right at book value, nine times forward earnings, and is flush with $5 billion in cash. A share buyback is also a distinct possibility. And its 2.6% dividend yield offers some cushion and downside protection.

Data drawn from Jardine Matheson’s website shows that its shares are trading at a 25% discount to net asset value. This is the clincher for me.

Another blue chip to put in your Hong Kong saddlebag is Swire Pacific Ltd. (SWRAY).

Founded in 1816, Swire is active in a wide range of commercial activities throughout Asia, including aviation, property, and retailing. It trades at just 60% of book value, and during the last quarter the company booked earnings 23% higher than a year ago.

Bottom line: Buying quality value in growth markets that are out of favor coupled with a disciplined sell strategy is the key to building wealth.

Good investing,

Carl Delfeld