The Tremendous Value In Chinese Banks (If You Can Stomach The Risk) by Joe Leider
There are three questions you should ask before buying a stock. Is it cheap? Does it have a future? Is it safe? If you can answer those three questions with a resounding yes, then you’ve found value. But when you ask those questions, you need the broadest and deepest sets of data possible. For example, if you want to buy Wells Fargo, you’d want to know its 10-year history as well as the results of its peers. In that vein, let’s look at 17 of the world’s largest banks by market capitalization.
Is it cheap?
In figure 1.1, I’ve plotted our banks by price-to-earnings and price-to-book ratios. While Canadian & Australian banks have decent p/e ratios, they are expensive when compared to book. Bank of America, which has struggled, looks expensive vis-à-vis earnings. The cluster that I’ve outlined contains mostly Chinese and European banks, though JPMorgan is included too. Let’s zoom in on these cheaper stocks.
Yarra Square Partners returned 19.5% net in 2020, outperforming its benchmark, the S&P 500, which returned 18.4% throughout the year. According to a copy of the firm's fourth-quarter and full-year letter to investors, which ValueWalk has been able to review, 2020 was a year of two halves for the investment manager. Q1 2021 hedge fund Read More
Instead of coloring by region, I’ve changed it to look at dividend yields. Now we have a nice 3-variable look at the cheapest banks. HSBC, Bank of China, Santander, China Construction Bank Corp and Industrial & Commercial Bank of China stand out by being cheap on both valuation metrics and paying strong dividends over the past three years. While a value metric, dividend is also one of the few true gauges of a bank’s cash flow. After all, it’s very hard to fake a dividend.
Does it have a future?
The sales and profits of these banks, in many ways, reflect the monetary policies of their central banks. American banks did well pre-2008, were destroyed by the financial crisis, and have since bounced back strongly. Chinese banks have grown throughout the period with relatively loose monetary policy (high rates of nominal growth, higher inflation). European & British banks have struggled to grow (relatively tight ECB policy, low rates of nominal growth). Canadian/Australian banks have done well (hence aren’t as cheap) because of their ‘just-right’ policies of approximately 5% yearly growth in nominal GDP.
Because of the sheer size of most of these banks, they should be around for the long haul. But Chinese banks are combining stellar growth with cheap valuations. What gives?
Is it safe?
We talked a little about dividends above. Below are the trends. A lot of the Chinese stocks don’t have the history of our other banks, but they do pay very high dividends compared to American banks. A couple European banks pay even more, mainly because fear about Europe’s macroeconomic situation has depressed stock prices. Remember when we were all guessing who owned bundled mortgages in 2007? Now we’re worried about enormous amounts of Southern-European sovereign debt. If Greece exits the Euro, the pressure will quickly hit Portugal, Spain and Italy.
As far as leverage, American banks have the lowest ratios (conversely, the most equity as a % of assets) among our sample. Everywhere else banks have a lot more leverage, making them less safe. With higher rates of expected inflation and nominal growth, China, Canada and Australia appear better able to support that higher leverage. Europe does not. Japan’s central bank appears committed to higher nominal growth in the future, but Mitsubishi UFJ Financial Group (MTU) is the 2nd-highest leveraged stock among the group. If deflationary headwinds hit Japan or Europe, then Mitsubishi and BNP Paribas will be in for a very rough ride.
Where is the value?
Australian & Canadian banks are not cheap because their revenue and income growth has been strong. Their central banks appear willing to tolerate higher inflation when there’s slow growth to keep expectations of nominal income stable. That way deposits and loans grow in lock step.
American banks stumbled, but have picked up steam as the Federal Reserve appears willing to tolerate somewhat-higher inflation to get things back on track. But with questions over the Fed’s commitment, American banks still seems relatively inexpensive. JPMorgan Chase (JPM) and Wells Fargo (WFC) appear to be good buys considering their strong performance and lower levels of leverage.
European banks look very cheap, but a lot of their future hinges on whether the ECB can keep expectations of nominal growth high enough to sustain the Euro zone. German officials seem too sanguine about a Grexit. If it happens, it will throw other European bond markets into turmoil. An interesting (speculative) play would be: short sell a weaker bank like Santander while buying call options on a stronger one like HSBC (which has another advantage being outside the Euro zone).
Chinese banks offer tremendous value, with leverage ratios higher than in the United States, but in line with Europe, Australia and Canada. The People’s Bank of China has a lot of room to ease monetary policy before hitting zero interest rates / zero inflation. That means massive Chinese banks like Bank of China (BACHY), China Construction Bank Corp (CICHY) and the Industrial & Commercial Bank of China (IDCBY) offer lots of growth, close to 5% dividends and attractive valuations per earnings and book value.
The leverage of Chinese banks is a worry. These major banks are state-owned, so are part of Chinese monetary and fiscal policy. If you imagine for a moment that the Federal Reserve owned Citigroup, Bank of America, JP Morgan and Wells Fargo during the financial crisis (which in a way they did), then gave them a lot of money to lend (again, not much imagination needed), then forced them to lend for large construction projects (this is the part that didn’t quite work out), you’d have the situation in China.
A bank’s assets are its loans. If Chinese bank loans consist of a lot of crap (bridges to nowhere) that will never be repaid, then the risk is large. Just how large? Consider Bank of China with $26 billion in net income, a $159 billion market cap (implied 16% return, and growing fast). It also has almost $2.5 trillion in assets, $1.3 trillion of which are loans. A 20% write-down of 10% of loans would mean a loss of almost $50 billion (two years of net income or one third of stockholder equity). Granted, this would be a huge loss and mean a lower share price for the short term. But being state-owned, Bank of China has a more explicit guarantee from the Chinese government than American banks. And if the risks to assets were that huge, you wouldn’t see such high and consistent dividend payments.
Also, loans go bad in particular sort of macroeconomic situation – deflation. Fears of Eurozone deflation are quite justified when you look at the political headwinds faced by the ECB in starting quantitative easing (even with prices falling and debt obligations on the periphery out of control). But fears of a Chinese deflation seem fantastical considering rates of real GDP growth over 7%, and rates of inflation between 1-2%.
Loans default when expectations of nominal growth slow. The Chinese government is hell-bent on keeping the economic party going because its very legitimacy depends on it. If you can accept the risk of short-term news stories on Chinese “bridges to nowhere” dampening returns, you just might unlock tremendous long-term value by buying Chinese bank stocks.
Disclosure: The author is long HSBC and WFC