EWH: Hong Kong Equities Are Not Cheap, But Remain Internationally Competitive

Summary

• Hong Kong equities are mainly exposed to financial sectors. Therefore, a rise in long-term interest rates are supportive for funds such as EWH.
• EWH offers mainly U.S. investors an opportunity to invest in Hong Kong equities, which include companies like AIA Group Ltd (a major insurance company).
• In terms of overall valuation, EWH is not cheap, with a normalization to the country market risk premium implicating downside potential.
• However, a directional comparison suggests that EWH still offers better value than U.S. stocks, which trade at even greater heights.
• EWH probably still remains a good alternative to U.S. equities, and a good international diversifier. I would be unsurprised if EWH outperformed.

The iShares MSCI Hong Kong ETF (NYSEARCA:NYSEARCA:EWH) is an exchange-traded fund that provides predominantly U.S. investors with the opportunity to gain direct exposure to Hong Kong equities. EWH provides exposure to large and mid-sized companies in Hong Kong, with 38 holdings in total (as of April 1, 2021). The expense ratio is 0.51%, which is comparable to other country-specific funds offered by iShares and other major providers.

The largest sector exposures that EWH has are: Real Estate (21.45% of the fund as of April 1); Insurance (20.57%); Capital Goods (13.99%); Diversified Financials (13.20%); and Utilities (9.21%). A full breakdown is provided below, in which you will also notice Banks represent a further 5.90% of the fund.

(Source: iShares.com)

If you add up together Real Estate, Insurance, Diversified Financials, and Banks, you have over 60% of the fund invested in these largely "financial" sectors. As such, EWH is in some ways a bet on higher interest rates and/or inflation.

As long-term rates have carried a hawkish bias over recent months, most notably in the U.S., financial stocks have been performing fairly well. Sectors such as real estate also tend to do fairly well in times of rising inflation. So, funds such as EWH, even if they are country-specific, are quite good diversifiers in terms of both geography and business cycle positioning. Yields could certainly fall back down (see chart below); however, in the case that rates continue to lift, EWH would be a reasonably good place to be.

The chart below is a long-term channel of the U.S. 10-year Treasury yield. Notice that the 10-year yield is potentially about to break out of the channel. If, however, the 10-year yield falls back into its long-term trend (even if after a short-term blip outside of the channel), while this may hurt financial stocks it will still likely hurt the U.S. dollar's rebound. And therefore, diversifying abroad (in foreign equities) is probably still appealing; a caveat in the case of EWH is that the Hong Kong dollar is effectively pegged to USD. So, EWH is unlikely to provide much FX protection in the case of lower rates and a falling USD.

(Source: TradingView. The same applies to price charts presented hereafter.)

For long-term rates to continue to fall, however, they would likely need to enter negative territory even in the United States. Otherwise, we are looking at a long-term languishing of rates at the zero lower bound, which (if history is any guide) is certainly conceivable. 2018 saw a breakout in the 10-year yield, although this proved to be an excellent time to buy bonds. The chart below is presented for good measure; the Hong Kong 10-year yield, which follows the same trajectory albeit in a generally wider and more disjointed pattern.

In my last article covering EWH, published at the start of the year, I expected EWH to perform reasonably well relative to U.S. equities considering its strong yield. So far, the price change between EWH and the S&P 500 has been neck-and-neck, currently in the range of 6.5-7.0% (U.S. equities currently have a slight edge). When it comes to "yield", earnings yields are more important than dividend yields for valuation purposes. Dividends are, after all, distributed earnings; we want to value the fund based on its total earning power, before dividends (which are often reinvested in the same security anyway).

As an update, then, EWH (per Morningstar data) is currently priced at a forward P/E ratio of 17.82. Inverting this ratio provides us with an implied forward earnings yield of 5.6%. This is how EWH is presently priced. Using Professor Damodaran's estimated equity risk premium for Hong Kong of 5.31%, and adding the current 10-year Hong Kong bond yield of 1.40% (as shown in the chart immediately above), we find a market risk premium (abbreviated: MRP) of 6.71%. In other words, EWH is technically "overvalued" in terms of our market risk premium estimate. For EWH to "normalize" with our MRP, we would find downside of -16.54%.

If we compare this to the Vanguard 500 Index Fund ETF (NYSEARCA:VOO), we find that VOO (per Morningstar data) is trading at a forward P/E ratio of 21.73, indicating an earnings yield of 4.6% (a full percentage point lower than EWH). Damodaran's equity risk premium for the United States is currently 4.72%, and the U.S. 10-year yield (in the penultimate chart above) is 1.67%. The U.S. MRP then, being 7.27%, implies potential downside for VOO of -36.73%.

Perhaps stocks are not overvalued and will not fall anytime soon. However, using this method of pricing/valuation we can at least see that, directionally speaking, Hong Kong equities are probably cheaper than U.S. equities. There are likely idiosyncratic reasons for this too, such as political tensions surrounding China and the Far East, as well as the fact that U.S. stocks are more diversified and tend to include faster-growing companies than the kinds of stocks that EWH is exposed to. Nevertheless, Hong Kong equities still look relatively appealing as a way to de-risk what would otherwise be a U.S.-only portfolio.

Note that EWH's largest holding is 20.57% in AIA Group Ltd (OTCPK:AAGIY) which represents the full Insurance sector exposure mentioned earlier. This is a fairly high level of concentration, but it has been brought about by this company's effective long-term compounding. It does present some risk due to the degree of concentration here, but AIA continues to perform relatively well and remains the largest public listed life insurance and securities group in Asia-Pacific (operating in 18 markets, not just in Hong Kong).

Our "delta" (difference) between our downside "normalization" scenarios would suggest that, again speaking directionally, EWH could potentially outperform funds such as VOO by around 20 percentage points. That is the difference between the projected forward return of the funds, if they were to normalize with their country-specific MRPs. Even if half of this difference comes to pass, EWH looks attractive, and if no outperformance comes to pass, EWH is still likely to provide some diversification value. Alternatively, you may want to use this information to explore investing in any of the single names held under the EWH fund, such as AIA.

I touched upon the FX component, too, earlier. HKD is effectively pegged to USD; the Hong Kong Monetary Authority (the country's central bank) intervenes if USD/HKD escapes its target band of 7.75 to 7.85. At the time of writing, USD/HKD is trading at about 7.78. In my last article covering EWH, you will notice USD/HKD was trading at circa 7.75, and since then, it has risen (i.e., HKD has weakened). A rise in the price of USD from 7.75 HKD to 7.85 HKD would only implicate a negative FX headwind of about 1.3% for EWH, so timing any FX intervention is not likely to be worthwhile (though consider yourself lucky if you are buying EWH at USD/HKD 7.75; a minor bonus).

What you will also find in my last article is that HKD is probably undervalued as a result of these central bank interventions. Therefore, if HKD is artificially held down within this band (and it likely will be), this could still help to support earnings outperformance locally; an artificially weak currency should help to support the international competitiveness of a country's exports. And should the peg ever be broken, I would expect a stronger Hong Kong dollar, which would likely lift asset values in USD terms, hence EWH would be well positioned. Overall, I do not see an unfavorable situation from an FX perspective, although there is no particular opportunity here either.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[katmandu100]

Too expensive and too much risk in my opinion.
Interesting data and commentary.