Nov 15, 2016

Market Fears on Chinese Banks Are Misplaced; Opportunity Abounds

Major market misperceptions and misunderstandings leave Chinese banks seriously undervalued. This blog goes beyond the headlines to seek the truth about the Chinese banks and why we believe the risk/reward is firmly skewed to the upside.

I started writing this blog with the intent of helping investors look beyond the headlines surrounding misunderstandings of Chinese banks, and better understand why we believe the risk/reward is skewed to the upside. However, what started as a blog ended up being a full report - and to the dismay of our Marketing department, I wasn't able to shorten the report into a concise blog without detrimenting important data.

We compromised, and in this blog, I share with you key points highlighted in the report.

  • Chinese banks are currently trading at depressed multiples on widespread fears of potential collapse. These fears are based on a prevailing view that non-performing loans (NPLs) are at dangerously high levels, as well as the embedded risk of bank-sponsored Wealth Management Products (WMPs), which get lumped in with ‘Shadow Banking’.
  • Two large Chinese banks held in M&P portfolios (China Construction Bank – CCB; and Industrial and Commercial Bank of China – ICBC) currently trade at ~0.85x Price/Book and 5.5x Price/Earnings. This is a significant discount to Canadian Banks (~1.7x P/B & 11x P/E); and even to the very challenged large European banks (0.6x P/B & 9x P/E).
  • We believe the true level of NPLs in the two Chinese banks we hold are much lower than the 8-15.5% headline figures being discussed for the Chinese banking system as a whole, under even the most bearish of scenarios.
  • It is our view that market concerns regarding on- and off-balance sheet exposure to WMP/Shadow Banking products are overblown. These are non-recourse instruments and credit quality is much better than market perception, indicating minimal risk here.
  • CCB and ICBC are adequately capitalized and have more than enough loan-loss provisions to withstand even the most bearish of scenarios without needing to raise significant (if any) external capital, including altering dividend policy. In fact, these two banks compare favorably to some Canadian banks.
  • Despite the significant (~45%) decline in the P/Book ratio over our 5.5 year holding period, our total return to date on these two banks is ~20%, and we now view these banks as extremely attractive investments going forward.