HBCYF - HSBC: Love The Dividends But Hedge The China Risk

Summary

• HSBC is under pressure to deliver increasing distributions to shareholders.
• The dividend path looks very attractive for 2023 and beyond with a 50% payout ratio, special dividend, and share buybacks.
• The elephant in the room remains China-related risks.
• Love the dividends but hedge the China risk.
• Avoid the risk of permanent loss of capital.

As an investor in banks, one of my key focus is to avoid permanent loss of capital. I am also always on the lookout for sustainably strong cashflows that ideally are uncorrelated across my portfolio. Some of my investments are positioned for inflation and higher interest rates (e.g. certain banks and natural resources) whereas others work well in a lower rates environment (such as REITs and bonds). I am also a contrarian at heart, so I often get interested in less crowded areas of the market. However, the first and foremost principle for me is to avoid permanent loss of capital.

HSBC ( HSBC ) is a recent addition to my income portfolio given its improved profitability that is powered by rising rates and the reopening of China. The improved performance certainly provides it with a substantial distribution capacity when it comes to dividends and buybacks.

The bank is also subject to significant pressures from an activist shareholder (Ping An Insurance Group Co of China holding ~8% of the shares) that has been lobbying for a split of its Asian and western operations. At the outset of the pandemic, Asian-based investors were furious that the Bank Of England banned UK banks from paying dividends (in contrast to the large U.S. banks). This was the genesis of the Ping An public campaign to break up HSBC. The management team, quite understandably so, has pushed back on the proposal given the complexity involved and presumed dis-synergies.

However, this activist campaign is also ensuring that HSBC needs to fend off the pressure by returning meaningful amounts of capital to shareholders rather quickly. For my income-oriented portfolio, this is exactly what I am looking for.

The Dividend Path for HSBC

On the Q4 2022 earnings release, HSBC announced a 50% dividend payout ratio projected for 2023 and 2024 as well as a return to quarterly dividends from Q1 this year. This was above analysts' consensus forecasts that expected the payout ratio to land in the low 40%. HSBC is also planning a special dividend of $0.21 to be paid in Q1 once the Canada disposal is completed as well as additional share buybacks. Finally, it indicated that it will also bring forward the announcement of buybacks to the Q1'2023 earnings results.

In short, HSBC is clearly returning a lot of capital to shareholders which is a very welcome development in this challenging environment.

The management team has also reaffirmed its target of >12% ROE for 2023 and beyond. With a payout ratio of 50% for the quarterly dividend, this should translate to well above a ~6% dividend yield for the stock.

Love The Dividend But Must Hedge The China Risk

One of the arguments made by Ping An is that HSBC's global structure is not tenable in an era of heightened U.S.-China tensions. And in my view, this is a key risk in the thesis or somewhat of a "grey swan" that can potentially annihilate investors' capital.

Like it or not, HSBC is facing political pressures from both the U.S. and China and is literally caught in the middle as it is regulated by the West (primarily U.S. and UK regulators) whereas most of its business is from Asia ( predominantly Hong Kong and China). Some examples of such events in recent years include:

• China state media accused HSBC of providing information that led to the arrest and detention of Huawei CFO Meng Wanzhou. The bank was labeled as a "pawn" of the U.S. government.
• HSBC was criticized by U.S. politicians for its support of China's new national security law for Hong Kong
• HSBC was one of several foreign banks that were asked by the Chinese government to not publicly endorse US sanctions against Hong Kong officials and effectively chose political sides which put them in a very difficult position as it needs to maintain good relationships with both China and the West.

These events have predominantly involved rhetorics only and have not escalated further thankfully. The real risk remains that the tension between China and U.S. escalates dramatically. This could potentially be triggered by China supporting Russia in the Ukraine war more actively and/or providing weapons or otherwise contravening western sanctions. A more serious risk is an elevation of risks or outright military incidents in the Taiwan Strait. HSBC will surely no longer be able to walk between the raindrops in such circumstances.

In such a scenario, the likely response from the U.S. would be sanctioning China and specifically Chinese banks. This would be an utter nightmare scenario for cross-border trade flow banking businesses such as HSBC which is highly reliant on access to USD clearing.

Even in less "dark" scenarios, increased geopolitical tensions between China and the West are likely to adversely impact the performance of HSBC. Whilst I hope none of this comes to bear, "hope" is not a strategy and that's why I believe investors should hedge their investment in HSBC. In my view, there is a meaningful probability that tensions with China will become much worse before they get any better, especially as we move into the 2024 presidential election cycle in the United States.

How To Trade HSBC?

I believe that an options strategy makes sense in the current circumstances. I hold the shares but then sell covered calls (effective price at ~20%+ above current price). I also buy puts that are deeply out of the money as I see the risks as quite binary. In that manner, I preserve significant exposure to the upside whilst protecting myself from a "grey swan" event and/or a very dark scenario involving China.

Final Thoughts

HSBC's underlying performance has been improving and generous dividends and buybacks are certainly on the cards. It is well on the path to generating greater than 12% ROE in 2023 and beyond whilst returning most of its profits to shareholders. It is also quite cheaply valued currently at ~7x forward PE.

I love the dividends and share buybacks but I also like sleeping well at night.

I am concerned that in the next few years, political tensions between China and the West will intensify (whether Russia or Taiwan related). HSBC will not be a good stock to hold in your portfolio if such adverse scenarios or conflicts do arise.

I remain bullish but utilize options strategies to reduce binary risks whilst generating additional income.

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