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People wearing face masks stand near a bank electronic board showing the Hong Kong share index at Hong Kong Stock Exchange on May 26, 2020.

Vincent Yu/The Associated Press

Hong Kong stocks have become mouth-wateringly cheap as Beijing attempts to tighten its grip on the territory and crack down on dissent. Value hunters with a sense of history may want to take note.

One way or another, the former British colony has found ways to prosper since the middle of the 19th century. It has soldiered through wars, plagues, geopolitical upheavals and shifts in political control, while establishing itself as a major financial centre.

China’s own self-interest suggests it is likely to refrain from permanently stamping out this long-running success story. If so, the outlook for Hong Kong stocks is much rosier than today’s dismal share prices would suggest.

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The iShares MSCI Hong Kong ETF (EWH-NYSE Arca) has tumbled 19.5 per cent since the start of the year. The Hang Seng Index, which tracks large companies on the Hong Kong market, is now trading for less than 10 times its underlying earnings per share.

As Fortune magazine recently noted, this is a valuation typical of a frontier market such as Argentina, Colombia or Sri Lanka, not an advanced economy such as Hong Kong. By way of comparison, U.S. stocks change hands for more than 20 times earnings, while Canadian stocks go for 18 times.

Why are Hong Kong stocks so cheap? For starters, they are not that well diversified – insurance, financial and real estate companies dominate the local listings. These industries are particularly vulnerable if confidence wanes and capital flees the region.

Vicious clashes last year between police and pro-democracy protesters did not help in that regard. The confrontations shattered the city’s peaceful image and demonstrated the brutality of Beijing’s power grab.

Then came the arrival of the coronavirus, which shuttered the economy. At the same time, growing tensions between Beijing and the United States put Hong Kong on the front lines of a new cold war between the world’s two great powers.

The biggest immediate threat is U.S. legislation that takes aim at Hong Kong’s special status under U.S. law. This status dates from an agreement signed in 1992 and allows Washington to treat the region differently than the rest of China in economic matters.

A new bill, passed by Congress last year, requires an annual reassessment of whether Hong Kong still deserves this distinction. U.S. Secretary of State Mike Pompeo said Wednesday that the Trump administration had determined Hong Kong does not, because it is no longer effectively autonomous from mainland China. As a result, Hong Kong is now exposed to a wide range of potential sanctions including tariffs, visa restrictions and restrictions on using U.S. technology.

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So why invest in this mess? Bargain valuations are one reason. The bigger reason, though, is that both the U.S. and China have more motivation than you may think to maintain Hong Kong as a buffer zone between their two economies.

Washington, for instance, may well decide there is little to be gained by rushing to impose the most onerous possible sanctions on Hong Kong. A heavy-handed approach would only provide China with even more reason to quash the pro-democracy movement and fully absorb the territory. Instead, Washington may move slowly to impose sanctions while holding out the renewal of special status as a carrot that it would be willing to offer in exchange for more autonomy for Hong Kong.

For its part, Beijing may conclude it makes sense to stand back and allow Hong Kong a measure of independence. The decision would amount to enlightened self-interest: Chinese companies still need to attract international capital and there are not many places that can make that happen.

About 200 mainland Chinese companies, including giants such as China Mobile Ltd. and PetroChina Ltd., now list their shares on the New York Stock Exchange, according to Citigroup. Many of these companies now have reason to be wary of the regulatory fallout that could result from growing trade tensions between the U.S. and China.

A vibrant Hong Kong stock exchange, operating in a quasi-autonomous Hong Kong, would be a natural alternative roosting spot for these companies. It would allow them to tap pools of foreign capital in a way that satisfies both Western and Asian investors.

“U.S.-China tensions have likely only heightened Hong Kong’s role as an offshore financial centre,” Citigroup economist Johanna Chua argued in a recent report. Investors who aren’t scared off by the current turmoil may want to place a speculative bet on the territory’s future. At today’s prices, you aren’t paying much for the privilege.

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