A Case Study in Valuation, Mean Reversion, and Patient Investing
On October 3, 2022, the Hang Seng Index (HSI) closed at 17,079.51, weighed down by extreme pessimism, regulatory uncertainties, and economic headwinds in mainland China and Hong Kong. In the article I published at that time – What is the expected rate of return of Hang Seng Index? – I estimated a 14.2% annual return based on valuation metrics and fundamental valuation models.
On March 19, 2025, the Hang Seng Index hit a 52 week high of 24,874.39 points. For an investor who bought at the 17079.51 level, the realized Compound Annual Growth Rate (CAGR) was approximately 15.78%, over a time-frame of 2.45722 years. And as of June 23, 2025, the Hang Seng Index closed at 23,689.13, delivering a realised Compound Annual Growth Rate (CAGR) of 12.78% over a 2.72008-year holding period. This article revisits that forecast and explores the lessons it offers about contrarian thinking, valuation-based investing, and the concept of mean reversion.
My 2022 Outlook for the Hang Seng Index
In October 2022, the Hang Seng Index was a market in distress. On October 3, 2025, the Hang Seng Index (HSI) closed at 17079.51 points. This represented a substantial 34.9% decline from its 52-week high, indicative of the prevailing market pessimism. However, from a value investing perspective, this downturn presented an intriguing opportunity. At that time, the HSI exhibited highly attractive valuations:
- Price-to-Earnings (PE) ratio: 6.45
- Price-to-Book (P/B) ratio: 0.6958
- Price-to-Sales (P/S) ratio: 0.8152
- Estimated Return on Equity (ROE): 10.79%
Leveraging these fundamental metrics and applying a common valuation technique that assumes a stable perpetual growth rate of 3% for the HSI, I estimated an expected rate of return of 14.20% per year. My analysis suggested that despite the widespread bearish sentiment, the index was fundamentally undervalued, hinting at significant upside potential.
From Projection to Reality: The Actual Return
Now, let us examine the actual realized returns for an investor who acted on the premise of value investing and acquired the HSI at our October 3, 2022, reference level of 17079.51 points, tracking its performance to two recent significant dates in 2025:
To estimate the realized Compound Annual Growth Rate (CAGR) for an investor who bought the Hang Seng Index at 17079.51 on October 3, 2022, we will calculate for the two specified end-points:
Beginning Investment Details:
- Beginning Value: 17079.51
- Beginning Date: October 3, 2022
The formula for CAGR is: CAGR = ((Ending Value / Beginning Value)^(1 / Number of Years)) - 1
1. CAGR to the 52-week High (March 19, 2025)
- Ending Value: 24,874.39
- Ending Date: March 19, 2025
Number of Years Calculation:
- From October 3, 2022, to October 3, 2023, is 1 year.
- From October 3, 2023, to October 3, 2024, is 1 year.
- From October 3, 2024, to March 19, 2025:
- October 2024: 28 days (31 – 3)
- November 2024: 30 days
- December 2024: 31 days
- January 2025: 31 days
- February 2025: 28 days (2025 is not a leap year)
- March 2025: 19 days
- Total days = 28 + 30 + 31 + 31 + 28 + 19 = 167 days
- Fraction of a year = 167 / 365.25 (average days in a year) = 0.45722 years
- Total Number of Years = 2 years + 167/365.25 years = 2.45722 years
CAGR Calculation: CAGR = ((24874.39 / 17079.51)^(1 / 2.45722)) - 1 CAGR = (1.45639^(0.40696)) - 1 CAGR = 1.1578 - 1 CAGR = 0.1578 or 15.78%
The realized CAGR for an investor at the 52-week high on March 19, 2025, would be 15.78%.
2. CAGR to the Closing Price on June 23, 2025
- Ending Value: 23,689.13
- Ending Date: June 23, 2025
Number of Years Calculation:
- From October 3, 2022, to October 3, 2023, is 1 year.
- From October 3, 2023, to October 3, 2024, is 1 year.
- From October 3, 2024, to June 23, 2025:
- October 2024: 28 days (31 – 3)
- November 2024: 30 days
- December 2024: 31 days
- January 2025: 31 days
- February 2025: 28 days
- March 2025: 31 days
- April 2025: 30 days
- May 2025: 31 days
- June 2025: 23 days
- Total days = 28 + 30 + 31 + 31 + 28 + 31 + 30 + 31 + 23 = 263 days
- Fraction of a year = 263 / 365.25 = 0.72008 years
- Total Number of Years = 2 years + 263/365.25 years = 2.72008 years
CAGR Calculation: CAGR = ((23689.13 / 17079.51)^(1 / 2.72008)) - 1 CAGR = (1.38699^(0.36763)) - 1 CAGR = 1.1278 - 1 CAGR = 0.1278 or 12.78%
The realized CAGR for an investor at the closing price on June 23, 2025, would be 12.78%.
Actual return for the two end-points
| Period | End Date | End Level | CAGR |
|---|---|---|---|
| 3 Oct 2022 → 23 Jun 2025 | Jun 23, 2025 | 23,689.13 | 12.78% |
| 3 Oct 2022 → 19 Mar 2025 (52‑week high) | Mar 19, 2025 | 24,874.39 | 15.78% |
In 2022, I estimated the rate of return of the Hang Seng Index to be approximately 14.20%. Given the simplicity of the model, and the assumptions that were made, the predicted rate of return actually turned out to be reasonably accurate compared to the realised returns as shown in the table above. A simple average of the two actual data points yields a value of 14.28%, a figure that is surprisingly close to the predicted return of 14.20%.
Deconstructing the Methodology: Assumptions and Validity
My original analysis relied on established valuation principles, utilizing fundamental ratios and projecting a perpetual growth rate. While the assumption of a stable 3% perpetual growth rate for a broad market index like the HSI is a simplification, it is a widely accepted practice in long-term financial modeling. This rate typically aligns with general economic growth or inflation expectations, providing a reasonable baseline for future performance.
It is crucial to understand that such models serve as tools for estimating intrinsic value and potential returns under specific conditions. They do not account for every market fluctuation or unforeseen event. However, by grounding the analysis in robust financial metrics like PE, P/B, P/S, and ROE, the framework provides a logical and defensible basis for investment decisions, particularly for value-oriented investors. The alignment between the estimated and actual returns in this scenario underscores the practical utility of this approach.
The Essence of Contrarian Thinking
The original blog post was a classic case-study in contrarian thinking. At a time when the Hang Seng Index was significantly depressed and market sentiment was predominantly negative, my analysis highlighted the underlying value and potential for recovery. Contrarian investing involves deliberately going against the prevailing market sentiment—buying when others are selling due to fear and selling when others are buying due to irrational exuberance.
This strategy thrives on the premise that markets often overreact to short-term news, creating temporary mispricings. The HSI’s low valuations in October 2022 were a direct result of this market overreaction, presenting an ideal scenario for a contrarian approach.
Mean Reversion: A Fundamental Market Principle
This case study strongly illustrates the principle of mean reversion. Mean reversion posits that asset prices, after experiencing significant deviations from their long-term averages or intrinsic values, tend to revert back towards those averages over time.
When the Hang Seng Index was trading at a PE of 6.45 and a P/B of 0.6958, it was well below its historical valuation norms, indicating a temporary undervaluation. As of June 23, 2025, the Hang Seng Index had rebounded to 23,689.13. According to data from Bloomberg, at this level, the PE and PBV of the HSI has reverted to 11.25 and 1.27 respectively.
The gradual recovery of the HSI over a period of more than 2.7 years, following a period of market pessimism, is a classic example of mean reversion in action. It suggests that despite short-term volatility, fundamental value ultimately exerts a strong gravitational pull on prices.
Strategic Investing: Patience, Valuation, and Enhanced Returns
The Hang Seng Index example serves as a powerful reminder of how a patient and disciplined investment strategy, rooted in contrarian thinking and value investing principles, can yield substantial returns. For investors, particularly those focused on the HKEX and dividend income, understanding these concepts is paramount.
Here is how a patient investor can strategically employ contrarian thinking:
- Waiting for the Right Opportunities: Instead of chasing hot stocks or reacting to market hype, the patient investor waits for periods when asset valuations are low and the market is “unloved” or “unpopular.” These are often times of economic uncertainty or widespread pessimism, when quality assets are sold off indiscriminately.
- Buying When Valuations are Low: This provides a crucial margin of safety. Acquiring assets at deeply discounted prices inherently lowers the investment risk. Even if the market experiences further declines, the downside is mitigated due to the already low entry point.
- Lowering Risk and Volatility: By focusing on undervalued assets, investors reduce exposure to speculative bubbles and their subsequent crashes. This approach typically leads to a smoother equity curve over the long term, as returns are driven by a return to intrinsic value rather than speculative fervor.
- Enhancing Potential Returns: The most significant returns are often generated when investors buy assets at a substantial discount to their true worth. As market sentiment improves and valuations normalize through mean reversion, investors benefit not only from general market recovery but also from the closing of the valuation gap, amplifying their gains.
In conclusion, the Hang Seng Index’s journey from undervaluation to recovery underscores that genuine investment success often lies in patiently identifying and acting upon opportunities when the market is most pessimistic. This approach, grounded in objective analysis and a deep understanding of value, remains a cornerstone for long-term wealth creation in the stock market.