UBS sees earnings growth momentum driving HK

Investors advised to stay bullish, but remain cool.

The economy of Hong Kong is still treading bullish waters, according to UBS, which has earmarked earnings growth momentum as the key driver for the territory's short-term health. Aside from looking bullishly towards Hong Kong's economy, the global firm also advises investors to move cautiously and be selective with banking stocks, warns of the pressures faced by certain industrial/exporters and generally predicts a positive scenario for the local residential property market.

"Earnings growth momentum rather than liquidity, which has never exerted a significant influence on movement in the Hang Seng Index, is the key driver of the economy in Hong Kong," says Andrew Look, managing director, UBS Investment Research, head of Hong Kong research, strategy & product.

When looking at the current and short-term state of the Hong Kong economy, Look identifies four key themes, which he believes will be the main characteristics going forward.

Primarily, Look stresses that earnings growth momentum is the key driver for the time being. He also predicts that fund raising activities will not adversely effect earnings growth. Indeed, despite the fact that HK$182.97 billion ($23.6 billion) was raised in the first three quarters of 2005 and Hong Kong-listed IPOs will raise around HK$105 billion ($13.55 billion) in the fourth quarter, Look believes that net equity supply (gross supply minus dividend payments) as a percentage of average market capitalization will not hurt sentiment.

"In 2005, we estimate that net equity supply is not too high with a forecast of 0.9%," he says. "Sentiment is not going to be hurt and we're not too worried about an influx of IPOs. The Hong Kong Stock Exchange (HKEX) should be in your pension plan."

Neither should investors be overly worried about the China-laden supply of new equity coming to the HKEX, although the market is not going to be cheap. However, as Look explains, as percentage of the total market cap of the HKEX becomes increasingly washed with China equity (estimated by UBS to be around 70% of total HKEX market cap by 2006), with an expensive market will be the price of attracting corporations while the RMB becomes a more international currency.

According to UBS, despite lower P/E ratios than Shanghai, Chinese corporations will continue to list in Hong Kong and the mainland's capital accounts are not going to open up anytime soon.

Neither does Look see many reasons for investors to fear the increased number of warrants emerging on the HKEX. He stresses that despite warrant turnover hitting HK$524 billion ($67.6 billion) in 2004 from HK$264 billion ($34.06 billion) in 2003, as a percentage of market it was not as high as market peaks several years back.

"Contrary to popular view, we regard neither the strong primary equity pipeline nor increasing warrant turnover as having the potential to derail the recovery," Look says. "It should also be remember that warrant turnover as a percentage of market turnover was not high at previous market peaks."

"For example, in September 1987 it stood at 5.37%; in December 1993 at 13.06%; in July 1997 at 10.84%; and in August 2000 at 7.77%," he continues. "However, large initial public offerings from China have fuelled growth in warrants and in derivatives in general."

Outside of the fund raising side, the UBS strategist also urges investors to be cautious on banking sector selections, suggesting that loan growth and volumes should be the deciding factor in swaying sentiment. Mortgage yields may still be a factor in his eyes, but he does predict a recovery in margins but not in volumes.

Among the banks in the territory, Look points to Hang Seng Bank and Dah Sing Financial as the shining lights on the local scene, with both institutions eclipsing domestic rivals in terms of personal loan market share, 22% and 19% respectively, and on ratio of risk-weighted balance sheet assets (RoRWA).

On the local Hong Kong industrials/exporters side, the major concern shaping their valuations clearly rest on the reliance on US consumer demand growth, which Look describes as not the healthiest economy around, due to the spike in household debt and job market uncertainty.

In term of top domestic picks in the industrials/exports sector, Look earmarks Johnson Electric as a relative value call due to their reliance on steel and copper for 35% of their turnover. UBS points to steel prices, which it anticipates will drop by 21% in 2005, and an expected peak in copper prices as the more attractive attributes to Johnson Electric.

In terms of Hong Kong's property market, the supply shortfall will continue to benefit landlords, with Sino Land and Great Eagle the investment bank's best picks on the local real estate market.

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