Real estate, the most significant sector of the market, took a large hit this year. The Hang Seng Property Index has fallen 20 percent since the beginning of the year. However, investors should pay close attention to this sector and start allocating funds.

Source: Bloomberg

The main reason for the sector’s recent underperformance is the general assumption that Hong Kong’s economy would be negatively affected by the global economic downturn as well as China’s expected slowdown. Nevertheless, the majority of relevant indicators continue to point toward relatively upbeat economic growth.

Hong Kong’s economy grew by a 7.2 percent annualized rate in the first quarter, and the majority of economists expect 5 percent growth this year. Consumption and investment were also strong, rising 7.9 percent. However, those numbers were stronger in the fourth quarter of 2007, up 8.9 percent.

Inflation–up 5.5 percent in April–continues to rise with food and utilities leading the way. This is a pan-Asian phenomenon based mainly on higher food prices. And, although higher inflation is generally a negative attribute for economies, it offers a great investment opportunity in Hong Kong.

Hong Kong interest rates are determined by the US Federal Reserve’s actions because the Hong Kong dollar is pegged to the US dollar. Therefore, as US rates remain low, so do Hong Kong rates. The main difference is that the high inflation in Hong Kong makes these low rates even more powerful. The result: Monetary conditions will continue to adjust as strong domestic demand pushes inflation higher.

I view the Hong Kong real estate market as the ultimate beneficiary because it remains one of the best hedges against inflation, especially in a low interest-rate environment. In addition, the economy is in a good position to handle higher inflation because its strong fiscal position will allow the government to introduce initiatives for weaker earners.

I made the same argument in the beginning of the year, but the real estate index chart above proved otherwise. See Silk, 9 January 2008, Difficult Times for Longs. But real estate data continues to indicate strength in the sector that will eventually translate into higher prices for Hong Kong developers.

For starters, the number of people in Hong Kong earning more than USD6,500 per month grew by 20 percent in the fourth quarter of 2007. Meanwhile, the median household income has also been rising. Employment and housing supply also remain relatively low.

I’ve updated some of the indicators, and the trend remains bullish for Hong Kong’s real estate sector. Prices continue to rise, reaching an average of USD526 per square foot, as the chart below depicts.

Source: Bloomberg

Housing supply remains low, and given the stricter building laws and the government’s focus on better living conditions, supply should remain low for sometime, allowing developers to get better prices for their properties.

Another development worth noting: A number of insiders have been buying their own stock in the open market, with the chairman of Silk portfolio holding Henderson Land (Hong Kong: 12, OTC: HLDCY) leading the way. In the first two weeks of April, he bought 15 million shares at an average price of HKD55, which is the approximate value of the stock now. The chairman of my long-term favorite, Cheung Kong (Hong Kong: 1, OTC: CHEUY), bought in at an average price of HKD116. The stock is now pricing in at HKD120.

Cheung Kong has one of the biggest residential land banks in Hong Kong: 17.3 million square feet. It’s a respectable player on the mainland, too. The stock trades at relatively cheap valuations, especially compared to the more leveraged construction plays. Cheung Kong is a conglomerate and has more room for upside and better downside support.

On the other hand, Henderson Land has a relatively smaller residential land bank of 5.8 million square feet, but it also has 31.7 million square feet of agricultural land that could be converted into residential land. In comparison, Cheung Kong has 15 million square feet of agricultural land. According to industry experts, agricultural land conversion will take place gradually in the next few years.

Henderson also has around 150 million square feet in mainland land bank, one of the largest among Hong Kong-based developers. Even with short-term drawbacks in the Chinese property market, long-term growth will be an additional kicker for the company. Valuation wise, Henderson is also one of the cheapest developers, and I expect this gap to close.

Although I’m not a big follower of insider buying and selling, this situation is appealing. These insiders have been buying strongly since the stocks were severely hit in the first four months of the year. In addition, they’re also the founders of these companies and tend to have impeccable timing when it comes to the future of the Hong Kong economy. 

Both Cheung Kong and Henderson Land are buys, and Hong Kong remains my No. 2 market behind Russia.

As always, it’s better to purchase Hong Kong stocks locally. The majority of serious brokers now offer this option for US-based investors. Liquidity is a plus in both up and down markets. Alternatively, you can buy the stock over the counter in the US.

Insider buying activity hasn’t been limited to the aforementioned companies. The practice has spilled into several other Silk portfolio holdings as well.

The chairman of China-based diaper and tissue producer Hengan International (Hong Kong: 1044, OTC: HEGIF) bought heavily in April.

This is also an old favorite of mine, and I still recommend it for exposure to China’s domestic demand growth. The company offers solid market leadership, ability to weather cost headwinds, earnings visibility and a cash-rich balance sheet. See Silk, 13 February 2008, Increasingly Stronger. Hengan International remains a buy.

Chine Infrastructure Machinery (Hong Kong: 3339, OTC: CIMHF, CIM) also saw plenty of insider buying activity in April after its stock dropped to HKD6. The chairman of the company as well as the government of Singapore bought heavily. The latter now holds a 5.06 percent stake in the company.

CIM is the second-largest loader producer in China under the brand name Longgong. It’s also diversified into producing forklifts and excavators recently, which should help future earnings growth. CIM remains one of companies that will benefit from the infrastructure boom in China and one of the few that’s easily accessible in the Hong Kong market. See Silk, 27 February 2008, A Year of Consolidation.

Although it’s been a disappointment since first recommended here in late February, long-term investors see value at these levels. Buy China Infrastructure Machinery.

Philippine Long Distance Telephone (NYSE: PHI, PLDT) also saw insider buying activity in March and May. The company is the country’s primary domestic telecommunications company.

PLDT is a relatively defensive consumer play that also offers a respectable 5 percent dividend yield. It’s currently benefiting from strong growth in domestic demand, a result of efforts to make its services more accessible through wider retail distribution coupled with rising domestic incomes and consumption.

Now is the right time to allocate funds in this stable telecom player; the Philippines is one of the cheapest markets in Asia, and the opportunity to start building some long positions is ripe. Buy Philippine Long Distance Telephone.

Finally, there was also insider buying activity in Singapore-based Keppel Corp (OTC: KPELY). Keppel is one of the best run companies in the world with interests in rig building, shipbuilding and real estate.

Although the company will be affected by the global economic slowdown, long-term investors should continue to build positions. The company’s stockholder-friendly policies will continue with increasing regular dividend payments and special dividend payments such as Keppel’s recent 40th anniversary dividend payout. Buy Keppel Corp.

Two weeks ago, I recommend shorting HSBC Holdings (NYSE: HBC). I made this recommendation before, but it didn’t play out well for us. The argument is the same this time around: HSBC holds 63 percent of its loans in the US and UK, and its stock hasn’t suffered nearly as much as the rest of the global banks.

I still expect it to be hit in a downturn, and it’s a good hedge to our long positions. Short HSBC Holdings at current prices, and place your stop at USD100.

The investment process is constant. So if you’d like to add to your positions in portfolio recommendations or allocate new funds in a diversified way, focus on the following markets, in order (for both countries and sectors). Consult the Portfolio tables for details.

• Russia (energy, telecommunications)
• Hong Kong (banking, real estate, infrastructure)
• India (pharmaceuticals)
• Taiwan (ETF)
• Philippines (telecommunications, real estate)
• China (consumer, telecommunications, machinery, oil, e-commerce, coal)
• Singapore (banking, telecommunications, industrial)
• Japan (banking)
• South Korea (banking)
• Cambodia (casino/hotels)
• Macau (casino/hotels)