Monday, August 1, 2011

Hong Kong Hang Seng Index Is Trading At a Very Attractive Level

A Bargain Buy Or A Value Trap For The Hong Kong Market? In this article, we use two different models to value the fair price of the Hang Seng Index (HSI) by the end of 2011.

Key Points:
* According to the Earnings Yield Gap Model, if there is a slightly improved sentiment in 2H11 which brings down the average risk sentiment back to the level in 2010, the fair price of the HSI would be 24,805 points at a 390 bps risk premium assumption, a potential upside of 13.1% from the market close on 14 July 2011.

* At present, the Hang Seng Index is trading at minus one standard deviation against its 5-year historical mean, which is the lowest in the post-crisis period. 14X FY11 earnings would represent a fair price of 25,830 points by the end of 2011 which equals a 17.7% potential upside compared to the market close on 14 July 2011.

* The Hang Seng Index is trading at a very attractive level.

The Hong Kong market represented by the Hang Seng Index (HSI) dropped 2.8% in 1H11, erasing most of the gains reaped last year. Nonetheless, many corporations continue to announce strong earnings that have beaten analysts’ earlier estimates and the consensus expects the earnings for the Hong Kong market to grow by 13.3% this year.

Meanwhile, headline news flow suggests that upbeat corporate results have been overshadowed by rising panic sentiment including the heightened European debt woes, China’s economic hard landing, shady governance of Chinese companies and US soft patch, to name just a few.

In this article, we use two different models to value the fair price of the HSI by the end of 2011. Although there is a disparity between a "fair price" and a "target price" in the equity market, we hope this fair price can shed some lights on whether a market is overvalued or undervalued and essentially, how much downside risk we have from the current level.

Earnings Yield Gap Model
One of the widely cited models to compute the fair price of the HSI is the Earnings Yield Gap (EYG) model (Andrew Look, the ex-UBS Head of Hong Kong Research has been one of the advocates of this model). In equation, it is written as

***** Equation 1: Index = EPS / (BY + RP), where
Index: Fair value of the Hang Seng Index
EPS: Earnings Integer of the Hang Seng Index
BY: 10-year US Treasury yield
RP: The Hong Kong Dollar Risk Premium

This model is not as complicated as it looks on the surface. Basically, it is extended from the Fed Model which compares a stock market’s earning yield with the market’s long-term government bonds.

Earnings yield is the reciprocal of the Price Earnings (PE) ratio. It is the amount of earnings you purchase for every dollar worth of the stock (i.e. if a market has an estimated PE of 12X, the earnings yield is 8.3%). Our research team monthly updates the earnings yields of markets under our coverage.

Compared to the Fed Model, the EYG model incorporates a risk premium (RP) of the Hong Kong dollar so as to capture the effect of market sentiment upon the stock market.

All parameters in the model are clearly defined, except for the RP which very much depends on an analyst’s subjective assessment. In other words, one analyst may give a risk premium of 230bps and another may estimates 130bps. Such disparity would produce a fair price of 31,592 and 38,120 respectively with the inputs we discuss below. Therefore, in attempt to form a basis for pricing a risk premium, we re-arrange the above equation as follows:
***** Equation 2: RP = (EPS / Index) - BY

Risk Premium of the Hong Kong Dollar

As shown in Chart 1, it seems obvious that the risk premium of the Hong Kong dollar increases whenever there is an event risk. With reference to the historical risk premium and few consensus inputs (Table 1), we compute HSI’s fair price using equation 1 along with a scenario analysis for different levels of risk perception (Table 2).

Table 1: Consensus Input
*** For the EPS, we use the Bloomberg consensus earnings of the 46 Hang Seng Index constituent stocks, adjusted for their respective free-float and cap factors. This gives us a FY11 EPS of 1845.5

*** We set the BY at 3.54%, which is the 10-year Treasury Bond Yield compiled by the Bloomberg consensus forecast

Table 2: Scenario Analysis on HSI’s Fair Price in 2011
Scenario Analysis on HSI Fair Price in 2011

As shown in Table 1, we take the bull-run from 2006 to 2007 as the reference point for the bullish case, in which the HSI could hit 34,318 which represents a 56.4% potential upside from the market close on 14 July 2011. In contrast, the bearish case – assuming Greek debt contagion could be a repeat of Lehman 2008 – would drag the HSI down to 17,918 points. Under a normal market sentiment, the fair price of the HSI would be 30,509 points.

The above analysis tells us how much bad news has been priced in. We think the European debt woes will not be a repeat of the Lehman’s collapse because

1. Sovereign debt worries are more manageable as opposed to a global financial crisis in 2008. The risk is comparatively contained within the region.
2. The total debt outstanding is more visible as opposed to the highly-complex CDOs.
3. While the toxic assets were hard to price, these sovereign debts are more price-transparent.

Although we can’t exclude any tail risks, as a worst-case scenario, a spike in risk premium back to the Lehman’s collapse would give a downside risk of 18.3% from the current level.

Our View
In our view, the European sovereign debt woes may keep lingering for an extended period and thus the market sentiment is unlikely to normalise (i.e. our normal case may not come true) in the near-term. However, we think the panic sentiment at the moment has been exacerbated (557bps as of 13 July 2011, just 119bps below the average risk premium during the peak of the financial crisis in 2008). We expect a slightly improved sentiment in 2H11 once additional bailout packages come up. The improved certainty will help bring the panic sentiment down to the level seen in 2010.

With reference to the average risk sentiment in 2010, the fair price of the HSI would be 24,805 points given a 390 bps risk premium, which represents a potential upside of 13.1% and an implied forward PE of 13.4X.

Historical MEAN PE Approach
Another commonly used yet simpler approach is to compare the market’s PE with its historical average. Historical data supports that a market’s PE tends to reverse back to the historical mean in the long run. In other words, a market offers greater value to investors if it is trading at below its historical mean.

At present, the HSI is trading at minus one standard deviation against the 5-year historical mean (Chart 2), which is the lowest in the post-crisis period.

Our Hong Kong market specialist assigns a 14X PE as the fair price for this year, after taking the weak sentiment into considerations. This is lower than the historical 15X average but slightly higher than the 13.4X implied PE in the EYG model discussed above. Such valuation would represent a fair price of 25,830 points by the end of 2011 which equals a 17.7% potential upside compared to the market close on 14 July 2011.

Hang Seng Index Estimated PE

Conclusion
If you get tired of the tedious mathematical calculations, just remember one key takeaway: The Hang Seng Index is trading at a very attractive level.



Source: FundSuperMart
Author : iFAST Research Team

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