Facets of HSBC- BoV equity premium puzzle

Any investor who invests in shares is always trying to answer this question: When do I know that the share price of a given company is right?

The value of a company should reflect its ability to generate earnings
- Robert Suban

A consumer’s trading will depend on the answer. A consumer will buy if he or she thinks that the company is undervalued, sell if he or she thinks the company is overvalued, and hold if he or she thinks that the price is right.

The proponents of the efficient market hypothesis state that any investor should not really worry about that question because there are enough investors doing the homework which will ensure that any share is fairly priced at all times.

Anyone who has been investing or following the markets for a long period of time knows that the markets are not fully efficient. In particular, the proponents of behavioural finance argue that the market as a whole can be subject to periods wherein investors are not rational and, as a result, share prices can deviate substantially from their fundamental value for long periods.

It is only when the bubble bursts that investors realise their collect-ive mistake and that prices will adjust once again to their fundamental value. This can happen for whole sectors, such as the techno-logy sector during the dotcom bubble of the late 1990s, or for individual stocks such as the likes of Facebook, Groupon or Zynga.

However, this phenomenon can also happen in the other direction, i.e. shares of companies can remain undervalued for sustained periods of time for no valid reason. Investors like Warren Buffett, engaging in so-called “value investing”, try to uncover such stocks, invest in them and wait until the wider investor community recognises the true value of these companies and appreciate accordingly.

We have such a case in Malta when one compares Bank of Valletta and HSBC shares. Given that both companies are fairly similar, their shares should have the same valuation. I admit that HSBC ought to have a small premium based on higher average earnings per share over the last few years. But for some years BoV shares have been trading at a discount whose size is certainly not justified when one compares the fundamentals of both companies.

Indeed, they have similar metrics in several areas, notably in terms of market shares and amounts of deposits, and have been generating the same amount of profits. One could argue that BoV ’s discount could be justified by the weight of the ongoing BoV-fund saga.

BoV’s profits were reduced by €15 million due to the compensation payouts given to the aggrieved investors, but BoV was more pro-fitable than HSBC in 2010. One could also justify the discount by the higher dividend payout ratio policy followed by HSBC compared to BoV. But ultimately, the value of a company should reflect its ability to generate earnings and not reflect how these earnings are distributed.

To use an analogy, the size of a pizza does not change according to the way in which we slice it. This is certainly a widely recognised fact as evidenced by the popularity of shares of companies which have had or still have a history of not paying any dividends (Apple, Microsoft, Google, etc.).

One reason the equity premium of HSBC shares has persisted for so long is that local investors have overlooked taking some metrics into account. For example, investors should not only look at the amount of the dividend but also take into account the dividend payout ratio. Instead of focusing on the nominal value of the share, they should compare that with their respective net asset value/share or look at the EPS.

Based on the latest annual accounts and even after taking into account the BoV fund payout, BoV’s NAV/share at €1.8146 is still higher than HSBC’s NAV/share at €1.3309. Likewise, if we compare the price/earnings ratio using the share price on October 10 of €2.17 and €2.70 for BOV and HSBC respect-ively, BoV’s P/E at 12.496 is lower than HSBC’s at 13.687. However, the EPS of BoV (17.365 cents) was lower than HSBC’s (19.726 cents), though if we were to remove the one-of effect of the fund settlement BoV’s EPS (21.427 cents) would have been higher than HSBC’s.

Such cases of under- or over-valuation which cannot be explained rationally are dubbed “puzzles” in finance. Investors trying to exploit these have to be armed with patience and focus on the long term, but should eventually see themselves vindicated.

Mr Suban is a full-time academic within the Department of Banking and Finance at the University of Malta.


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