It might be surprising… but today I’m going to recommend that you add some Chinese bank exposure to your portfolio.
This sector was an unloved area for many investors between 2013–2016. It was a time of sharply rising debt in China, and the risky shadow banking sector (i.e., off-balance sheet opaque lending) was growing rapidly, with few apparent controls. The Chinese equity market had also soared into bubble territory, and crashed sharply in 2015.
On top of this, the country was seeing its foreign exchange reserves run down as investors poured money offshore. This in turn produced significant downward pressure on the currency.
In a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More
China’s banks are healthy…
Many of these concerns have dissipated over the past year. Recognising growing risks in the financial sector, the Chinese authorities took a range of evasive actions to reduce risks in the banking system.
These included curbs on access to foreign capital and curbs on Offshore investment. Controls were put on lending by banks and on organisations in the non-bank financial sector (shadow banking). This included the unwinding of some shadow banking and interbank activities, controls on wealth management operations, trust structures and interbank lending structures. Policies have also tightened mortgage lending in the residential property market.
These measures have led to stability of the currency. Devaluation risks are much less of a concern to investors now compared with the near panic in 2015 when the currency fell by a few percentage points.
The country’s reserves have also stopped falling and are now picking up again.
From growing at double-digit rates in the earlier part of this decade, growth of bank assets (loans advanced by banks) shrunk to 4.4 percent in the first half of 2017 for the top 16 banks, according to Moodys. This suggests that lending growth is being reined to a healthier rate.
The problem loan situation is also improving. Although published figures of non-performing loans (NPLs) are questioned by some analysts, loans designated as “special mention loans” – problem loans – have declined as a percentage of total loans to a little over 3 percent. Reported 90-plus day delinquencies have declined and all major banks have made provisions for more than the 90- day amounts on their books.
… and much safer than most investors realise
This all points to improved asset quality amongst banks in 2017. The big 16 banks had an average Tier 1 capital ratio of 10.85 percent (the minimum U.S. requirement is 8 percent). This measures a bank’s financial strength. Tier 1 assets are composed of common stock (and also potentially preferred stock) and retained earnings, expressed as a percentage of its total risk weighted assets (being total assets but weighted by their respective credit risk).
This has fallen slightly, particularly at the big four Chinese state-owned banks, largely due to increased dividend payouts.
With the slowdown in loan growth, bank profitability has come under some pressure, though profits have continued to grow. Net interest margins have contracted slightly (which means less profit for the bank in terms of its lending interest versus its borrow interest). This has more than offset the benefits of lower loan loss provisions – reducing these provisions frees up more capital.
For most banks, loan impairment charges as a percentage of total loans have been falling, which again means lower loan losses.
All in all, the major Chinese banks have de-risked their businesses and portfolios over the past 12 to 18 months. This has perhaps come at the expense of earnings, but that is probably a worthwhile price to pay for medium- to longer-term comfort of a lower risk investment.
Stability above all
“Financial stability” has been the guiding mantra at the top of the national policy agenda over the past year or so. That is likely to continue to be at the heart of economic policy over the course of the coming year.
Policy moves have reduced the risks of a financial crisis in China. Also note that a great deal of bank lending by the big state owned banks is to state owned enterprises (SOEs). In a way, this can be viewed as government to government funding.
Re-structuring of the SOE system is slowly taking place, more slowly than many would like. But it is happening. Moreover, it is very unlikely that the central authorities would allow defaults in the SOE system to torpedo the health and survival of the big policy banks.
Finally, if the four big policy banks need to raise additional capital, they would certainly be able to do so.
The four big policy banks in China include Bank of China, Industrial and Commercial Bank of China (ICBC), China Construction Bank and Agricultural Bank of China. ICBC is the largest bank in the world today by some metrics. Their shares have all performed well in the past year – seeing gains of almost 25 percent (Agricultural Bank) to almost 47 percent (Bank of China). The other two have gained 40 percent.
Chinese banks are cheap
Despite the gains, the stocks are still cheap on the important metrics of price-to-book (P/B) ratios and price-to-earnings (P/E) ratios. For example, all four banks trade at prices below book value, with three in the range of 0.7 to 0.79, while Construction Bank trades at 0.97 book.
Typically, when stocks of big banks trade at prices substantially below book value, the bank is in some kind of distress, or banks broadly in the market are facing structural problems. Well, that is far from the case with the big four in China. They are not in a distressed situation. In fact, most of their risk characteristics have improved in the past year and will continue to do so in the coming months.
They are also trading at very modest P/E ratios. The sector as a whole is trading at around 9.6 times forward earnings, the lowest sector earnings multiple in the Chinese market. And the four big banks are trading at even lower valuations of between 6 and 7.5 times earnings. Again, that is cheap on a global basis. Earnings for the sector are expected to grow by around 12 percent in the coming year.
In short, both the top-down picture and valuations lead us to believe it’s time to take a position in the sector.