Asia

Is this the cheapest oligopoly in the world? (Part II of II)

Part I looked at the “big four” Chinese banks – their massive size, their essential role within China’s economy, their domestic market dominance and their high levels of profitability. In part II we’ll look at their incredibly cheap shares, and what they mean for investors.

As a reminder, the big four Chinese banks are:

  • ICBC: Industrial and Commercial Bank of China (HK:1398)
  • CCB: China Construction Bank (HK:0939)
  • ABC: Agricultural Bank of China (HK:1288)
  • BOC: Bank of China (HK:3988)note: not to be confused with the People’s Bank of China (PBOC), which is the Chinese Central Bank

So let’s get into valuations. For this I’m looking at the H-shares, which are traded in Hong Kong and priced in Hong Kong dollars. (See more on the different types of Chinese shares here, here and here).

First here’s a chart of the share prices for the past 10 years (ICBC in blue, CCB in red, ABC in green, BOC in yellow). They’ve been up and down, but the overall trajectory has been sideways.

Chinese-Bank-Share-Price

Over that time frame these businesses have seen massive underlying growth, along with the Chinese economy as a whole and its money supply.

For example, ICBC’s assets were three times as big at the end of June 2015 as they were at the end of 2006, measured in renminbi yuan. That works out as annual growth of 12.3% a year, with compounding. Yet the share price languishes close to levels last seen in 2006.

When analysing bank shares one of the most useful and widely used measures is the price-to-book-ratio (P/B). The average P/B of these banks is 0.8, and with little variation within the group.

Such a low P/B means the share prices would have to rise 25% before these banks traded at liquidation value, which is when the P/B is equal to 1.

If P/B is less than one it means that you could buy the whole company, sell off all its assets, use the cash to pay off all debts and be left with a healthy profit. This assumes that the balance sheets are reasonably accurate, and that reported assets and liabilities reflect their real values.

You’d usually expect the shares of a big and highly profitable bank to trade around twice that level.

Next we can look at how the shares are priced relative to earnings. The average P/E of these bank shares is just 6.8, using results from the first half of this year. You’d usually expect the shares of a big and highly profitable bank to trade around twice that level.

Perhaps most interestingly the average dividend yield is a very high 7.5%. That’s an extremely tempting level in a low return world.

This high yield on Chinese bank shares is not just because the share prices are so low in relation to earnings. These banks pay out a big portion of profits to shareholders in the form of cash dividends. On average I calculate that 51% of profits are paid out to shareholders.

So much for valuations. If these Chinese banks are so big and profitable, despite their modest leverage by international bank standards…and given they operate in a government protected oligopoly…how come the shares are so incredibly cheap?

Is this an incredible investment opportunity, or is the market telling us that China is about to implode?

And even if China does have a crisis, isn’t it already baked into the share prices?

Most people, including the Chinese leadership, accept that China’s economy is set to grow more slowly this year than in the past.

There are very mixed views on the state of the Chinese economy and financial system. Most people, including the Chinese leadership, accept that China’s economy is set to grow more slowly this year than in the past. But the big unknown is by how much, and whether the result will be some kind of debt crisis.

If there is a crisis – and it’s a big if – then that would clearly be very negative for the banks. They would have to take asset write downs which would hit profits hard for a year or two. If the write downs were big enough to turn annual profits into losses then they would eat into the all important capital bases.

The official Chinese GDP growth target is 7%, and this is what the government still expects to report in 2015. GDP is open to manipulation by all governments. It can easily be goosed up by extra government spending. But in the case of China many people believe the calculation itself is heavily manipulated.

Private estimates of GDP growth in China often point to lower figures than official statistics. For example analysts at Citigroup, a bank, predict around 4% this year. Still not a technical recession, but a long way from the 10% plus rates seen only a few years ago.

Another thing that’s got people worried are debt levels, both private and public. Recent analysis by Bloomberg, a news a data service, suggests that worries could be overdone. Bloomberg analysts Tom Orlik and Fielding Chen estimate that in 2013 the total assets of households, corporations and the public sector amount to 900% of GDP, versus debts of 220%.

They also point out that household debts are just 17% of real estate assets, implying that property prices would have to fall by more than 80% before there was widespread “negative equity” among homeowners.

Another concern has been the bubble and crash of the domestic Chinese stock market (see here for more). But I reckon this is overdone. Stocks are estimated – also by Bloomberg – to make up just 2% of household assets.

Of course some stock speculators will have lost their shirts. But it’s not such a widespread or large problem as if a meltdown occurred in certain other assets. 70% of household assets take the form of real estate and 24% are bank deposits. That last figure is a reminder that the banks won’t be allowed to go bust. Too many people have too much money at stake.

Then there was the widespread panic caused by the so-called “devaluation” of the Chinese renminbi yuan, the local currency. In fact it’s down only 4% since July against the US dollar. That’s hardly anything to write home about – which hasn’t stopped a huge amount of breathless headlines being produced on the subject.

Plus, to put it into further perspective, the renminbi was previously UP 35% against the dollar since June 2005. It was also UP 54% against the Japanese yen over the same period.

However, concerns remain that more devaluations are on the cards. But this certainly isn’t the official policy. Chinese premier Li Keqiang said just this week that continued renminbi devaluation is “not our policy preference”.

It’s only natural that he would say that. There’s a long history of leaders making such pronouncements in the face of currency speculation. But by making such clear statements of intention the Chinese leadership will lose credibility if devaluations continue.

Another issue that people are focused on is trade. In the year to August, measured in US dollars, exports were down 5.5% and imports were down a massive 13.8%. But the good news is that China enjoyed a trade surplus of $60 billion in August alone.

It’s no surprise that Chinese exports are under pressure. Japan has been pursuing a mercantilist policy of devaluing the yen to gain share of world export markets. And most of Europe, an essential export market, has a weak economy.

Meanwhile the falling value of Chinese imports is heavily influenced by weak commodity prices around the world, which are now at their lowest levels since the late 1990s (see here).

China is the world’s biggest importer of most important commodities, and the prices have been falling. There’s evidence that volumes are down as well, but I don’t think too much should be read into the fall in value. Cheaper commodities provide a boost for much of China’s economy because they mean lower input costs.

In any case, retail sales in China grew 10.5% in the year to July. Fixed asset investment, in infrastructure and the like, was up 11.2%. While these figures may have been a shade below consensus predictions they are still fast rates of growth in their own right.

There’s one thing that is certainly clear. A great many people have been predicting an economic and financial meltdown in China for as long as I’ve been following it, which is about 15 years.

The motives are partly political, since China isn’t a democracy and therefore it’s assumed it will fail.

There is also an element of wishful thinking, with many hoping that China’s path to power takes a sharp deviation.

And part of it is genuine concern over things such as growing corporate debt levels, or over-investment in real estate and infrastructure.

Whatever the worries, the predicted China crisis never quite seems to arrive. Obviously it will one day. China isn’t immune to economic cycles. And recent stock market action shows that it clearly isn’t incapable of speculative bubbles and busts. As long as it’s populated by humans then that will always be the case.

My own view is that the Chinese bank shares are almost certainly oversold. There are always big risks when you invest in banks, because it’s never possible to know what’s really lurking on their balance sheets, however detailed the disclosures may appear.

But these shares are so cheap, and with such high dividend yields, that they could be very rewarding to investors in future. The business risks are quite high given China’s slowdown, but the share prices are very low. Balancing out both factors brings the investment risk back to a modest level.

The outcome for investors in these depressed Chinese bank stocks is likely to be either making a lot of money, or losing a lot of money, with not much middle ground.

Investing in the big four Chinese banks is not for the faint hearted. In fact most private investors should probably steer clear. Even those that choose to get involved should only invest a modest amount.

But if you’d like to earn dividends of 7-8% a year, with the potential for big capital gains, then investing in the Chinese banking oligopoly offers that prospect.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

PS: Share prices in Hong Kong at time of writing: ICBC HK$4.33; CCB HK$5.06; ABC HK$2.88; BOC HK$3.81

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.