The big news in Hong Kong today was the announcement by HSBC Holdings Plc (HSBC) of the cancellation of the dividend announced on February 18 with an ex-February 27 date that was due on April 14. HSBC stocks are down 7% in Hong Kong today on the news and are currently down almost 9% at the time of this writing, and we should probably expect stocks traded in London and the ADRs traded in New York are trading today in a similar range if there is no other significant news.
Dividend cuts or cancellations feature prominently on the list of things that hurt investors’ earnings in the short term, but of course what really matters in the long term is how these dividends are recover and grow over time. Later in this article, I will highlight some of the dividend quality indicators that I look for in a bank, and why I don’t think anyone should have been surprised by this drop in dividend.
First, here is a screenshot of the cancellation announcement printed at the end of the “Details” section on the first line of “Rights” (mainly dividend registrations) on the HSBC page on the Hong Kong Stock Exchange website:
US-based ADR investors should note that one ADR equals 5 common stocks traded in London or Hong Kong, so please multiply these numbers by 5 if you are looking at the ADR. Multiple ADRs are available on this BNY Mellon site.
The history of HSBC was probably a “surprise” to dividend investors in Hong Kong, as the name is often considered the bluest of the blue chips here. Even 27 years after moving its headquarters from Hong Kong to London, HSBC is still known locally as “Hong Kong Bank”, and is one of the top three components accounting for 9.6% of the flagship Hang index Seng from this financial center. More than half of the counterparties with which I have done business in Hong Kong have an HSBC account, and almost all the other banks in this city have the feeling of being in a different category, partly reinforced most of the other banks all part of a completely separate non HSBC sector ATM network called Jetco. In 2017, I wrote about how the purchase of HSBC shares could be described as “a gamble on the continued customer convenience of the Hong Kong bank customer” based on my own experience with their services. At the time, I stressed that HSBC should always be considered a local bank mainly in Hong Kong, rather than “the local bank in the world”, because at the time, Hong Kong provided 1/3 of the base of HSBC deposits and more than 100% of its 2016 Pre-Tax Profits.
HSBC dividend history
Looking back, I find it useful to take a look at HSBC’s longer-term dividend history and how it compares to those of other banks. This week at Long-term income, I’ve done “dividend checks” on several different bank stocks that are often held for their dividends. We saw a similar pattern of large dividend increases from 2000-2008, followed by deep dividend reductions during the global financial crisis of 2008-2009, and a dividend that has since been raised to about half the levels of before 2008 in the last decade.
These deep dividend cuts in recessions should come as no surprise to anyone who understands the basics of most banks’ business models:
- Collect $ 10 of equity, then borrow an additional $ 40-60 from short-term depositors and an additional $ 30-50 from long-term bond holders. Try to keep your interest charges on these deposits and bonds as low as possible.
- Invest the $ 100 you put together in assets (mostly loans) that earn you a net interest rate (after losses) significantly higher than the interest you pay on your deposits and bonds.
The trade-off between using deposits and using long-term bond financing is generally trade-off between short-term liquidity and higher overall borrowing costs, and this is a key balance on the liability side. On the asset side, of course, the key is to generate high returns and minimize losses, since losing just $ 5 of the $ 100 in the example above would destroy half of the shareholder value. The graph below is very rough, but aims to give a longer-term idea of how HSBC is used and the sensitivity, even small errors on the asset side, can translate into significant write-downs of the book value.
HSBC’s low profitability ratio
One measure I often use to measure how well a bank is managing this is the return on assets ratio (ROA). In general, I prefer to keep the stocks of banks only when they maintain a ROA greater than 1% / year. This 1% / year is pretty much the best “safety margin” I have seen in most banks, and translates into a ROE of 10% on a bank that has increased its equity 10: 1, and I could earn 10% / year when I can buy these shares at book value and avoid losses in book value. However, as the graph below shows, HSBC’s ROA has remained below half of this desired level of 1% for most of the past decade, despite its leadership position in the Asian financial center. For comparison, the ROA of Wells Fargo & Co (WFC) has remained above 1% for most of the decade since the financial crisis.
While a more specialized banking analyst could take a closer look at HSBC’s balance sheet and business line portfolio, the above snapshots of HSBC’s leverage and low profitability ratios have allowed me to ‘Avoid buying stocks from this bank in recent years. Although I consider HSBC to have a very clear “gap” in Hong Kong’s retail banking, which is a very important industry for them, this gap did not translate into robust profitability which would have helped me. given confidence in its dividend. Any HSBC “gap” could look even narrower as I move away from Hong Kong, where it has clearly lost the image of being “the local bank of the world” in many places where I travel for business. Without more safety margin around his dividend, he should not have surprised anyone that the dividend was reduced as the panic of the coronavirus deepened. Instead, one should wonder why they still announced the full $ 0.21 on February 18, even if they should have known more about the impact of the virus on their loan portfolio in China than almost any other non-mainland Chinese bank. It is easy to say in hindsight “they should have known better”, but a bank with the size and level of penetration of HSBC in China should have had the risk management framework in place to ask whether the epidemic that peaked in China at the time would have put the dividend at risk. Until we see clearer improvements in some of these financial quality and risk management measures, I will continue to avoid holding HSBC stocks and, by extension, largely avoid the Hang Index Seng.
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Disclosure: I have / we have no positions in the stocks mentioned, and we do not intend to take any positions in the next 72 hours. I wrote this article myself and it expresses my own opinions. I do not receive any compensation for this (other than from Seeking Alpha). I have no business relationship with a company whose actions are mentioned in this article.