Why HSBC could be a value trap and what I’d buy instead

You could approach HSBC Holdings (LSE: HSBA) as a dividend-first investment, but I think that would be a mistake. Although I can understand why the dividend attracts investors. Today’s share price close to 649p throws up a forward yield for 2019 near 6.2%, which looks like decent income, but the stock comes with some big risks.

The pace of annual dividend growth has been pedestrian and it’s forecast to slow down. Between 2018 and 2019, City analysts following the firm expect the dividend to grow just 0.7%. With any firm, I tend to view the directors’ decisions regarding the dividend as a good test of what they think about trading and the underlying prospects of their business. To me, HSBC’s dividend growth outlook says “caution!”

There may be trouble ahead

And there are good reasons to be cautious. Although revenue and earnings are likely to creep up over the next couple of years, the stock market has been discounting the firm’s progress on earnings by dialling down the valuation. The process of valuation-reduction has been going on for a few years and it reflects in HSBC’s share-price chart. Apart from jumping up and down, the share price has made zero progress upwards since the beginning of the century.

I think the market is capping the share price because HSBC is a cyclical business. Earnings typically wax and wane along with the ups and downs in the wider macroeconomic environment. I think the market is viewing decent earnings at HSBC now as a step closer to the peak in its earnings for the current cycle. The risk, of course, is that earnings could plunge at some point, which could take the share price and the dividend down too. That’s why I think it is better to view HSBC as a cyclical investment first and a dividend opportunity secondly. There are risks in holding the stock and to me, it’s not worth the worry. I think the stock is a value trap.

Progress in mixed market conditions

Instead, I’d consider other firms in the wider financial sector such as UK-based interdealer broker TP ICAP (LSE: TCAP). The company updated the market today on trading for the four months to 31 October. Constant currency revenue rose 1% compared to the equivalent period last year and it’s up 3% so far this year.

Chief executive Nicolas Breteau said in the report that the firm is “well placed” to grow in mixed market conditions, “characterised by periodic volatility that we saw in October following the US Federal Reserve’s rates decision.” He explained that the directors have a “firmly-held belief” that investing in growth areas such as Data & Analytics will benefit the firm over the longer term as it develops “solid and scalable” revenues in its worldwide businesses.

The company also announced the acquisition of Axiom Commodity Group, an energy and commodities broker based in the US, which underlines the firm’s ongoing focus on growth. I’d rather take my chances with TP ICAP than to bet on an out-and-out cyclical firm such as HSBC.

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Kevin Godbold has no position in any of the shares mentioned. The Motley Fool UK has recommended HSBC Holdings. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.