Get 40% Upside From Chinese Banks

The markets have not been kind to the Chinese equity market this year. Since its peak in January 2018, the Hang Seng China Enterprises Index (HSCEI), which tracks the performance of major mainland Chinese companies listed in Hong Kong, has tumbled by more than -20%, officially putting it in bear market territory. The financial sector, which makes up almost 60% of the index (Chart 1), was not spared from the recent market turmoil either.

In particular, China's big four banks – Bank of China (HKEX.3988), Industrial and Commercial Bank (HKEX.1398), China Construction Bank (HKEX.939) and Agricultural Bank of China (HKEX.1288) – have taken big hits since the HSCEI peaked in January 2018, recording an average maximum drawdown of more than -30%.

Chart 1: Financials Make Up 60% Of The HSCEI

What Happened To Chinese Banks?

Fears Over China's Mounting Defaults: Three years ago, China embarked on its nationwide deleveraging campaign with the aim of reducing the ballooning levels of leverage and risks within its financial markets caused by years of excessive borrowing, fuelled by easy credit available from the shadow banking system.

To accomplish this, the government has implemented several measures, including tightening rules on the issuance of wealth management products, introducing leverage caps, provision requirements and limiting the local government's ability to borrow.

In the wake of Beijing's deleveraging campaign, there has been a spike in the number of defaults this year as it has become harder for companies to refinance their loans (Chart 2). This suggests that Chinese regulators seem to be increasingly comfortable with letting debt-ridden firms fall, raising concern among investors.

Chart 2: Defaults In 2018 Have Already Surpassed Previous Highs

Escalating Trade War Tensions & Weaker Economic Growth Expected: Since the US-China trade war started earlier this year, the Chinese market has been on a downtrend for the most part. With exports still playing a substantial role in China's economy, a further escalation in trade war tensions is likely to have a detrimental effect on China's economy, as well as dampen investor sentiment.

China's economy is being squeezed by the trade war with the US on one end and its domestic deleveraging campaign on the other. As China works to resolve its trade issues while at the same time stepping up its efforts to cut leverage back at home, it is inevitable that the Chinese economy will undergo a period of slower growth.

While the concerns about China's economic slowdown are legitimate, we feel that investors have been overly bearish, resulting in an excessive sell-off. At current prices, we think that the big four banks still offer tremendous value, and their share prices could soon experience a re-rating due to the following reasons.

1. Stronger Loan Growth Expected

Total new bank loans jumped nearly 20% to CNY 11.7 trillion for the first eight months of this year, up from CNY 9.9 trillion in the same time period of the preceding year. Overall loan growth remains robust even amid a nationwide deleveraging campaign (Chart 3). SMEs, which comprise 95% of all firms and employ 80% of the working population in China, are expected to be one of the key drivers of loan growth.

Chart 3: New Monthly Loans Continues To Grow Strong

Despite the vital role they play in China's economy, SMEs have long faced financing difficulties as they are often perceived to be riskier than large SOEs. To pledge more support for the real economy and encourage banks to boost lending to SMEs, the PBOC implemented several measures and incentives, such as tax breaks, flexible loan quotas and even setting up a national fund to guarantee loans. All in all, we expect the pickup in SME loans to contribute to the overall loan growth in China.

China is gradually moving towards full interest rate liberalisation, which means banks will have more freedom to adjust deposit rates, making them more attractive to savers. Combined with the crackdown on shadow lending, the net effect is very likely to drive both borrowers and savers back to the banks for their funding needs, a positive for banks as this increases their capacity to cater to the increasing loan demand.

2. Improving Asset Quality And Healthy Capital Adequacy Ratios

As the government presses on with its deleveraging campaign, defaults have been a major concern for investors. Year-to-date, we have seen CNY 32.4 billion worth in public bond defaults, already surpassing the total for last year. However, it is worth noting that the bad debts are mainly concentrated within the rural banks, and the asset quality of the big four banks remains strong.

While the NPL ratio for the overall banking sector rose in 2Q 2018, it was largely caused by a sharp increase in bad debts found in rural banks, where the segment's NPL ratio hit a high of 4.29% last quarter (Chart 4). The big four banks, on the other hand, saw an improvement in their NPL ratio from 1.50% to 1.48%, and is currently the lowest across the entire banking sector.

Chart 4: Bad Debts Mostly Concentrated Within Rural Banks

Besides the improving asset quality, the big four banks on average holds one of the healthiest capital adequacy ratios amongst all Chinese banks at 14.6%, which is also higher than the requirements under Basel III. This means that in the event of a market downturn, they have a bigger cushion to absorb losses.

3. Potential Recovery In Net Interest Margins

The net interest margin measures the difference between the interest income and the interest expense, relative to a bank's net assets. Widening net interest margins is a positive for banks as it means interest income is greater than interest expense, leading to an overall increase in profitability.

Given how net interest margins generally follow the direction of interest rate spreads, observing interest spreads can offer clues as to how net interest margins will move. In addition, because deposit rates are guided by shorter-term rates and bank lending rates by longer-term rates, we can use the spread between the 10Y and 1Y bond yield as a good proxy for net interest margins.

Based on the data below (Chart 5), net interest spreads have been on the uptrend for the most part since the A-share market bottomed out in mid-2016. And as China continues its journey towards full interest rate liberalisation, we expect net interest spreads to continue widening, which would in turn lead to a recovery in net interest margins, a catalyst for the share prices of banks to re-rate.

Chart 5: Net Interest Margins For Chinese Banks Are Expected To Widen

4. Sustainable, High Dividend Yields

The average dividend yield of the big four stands at an attractive 6.35%, which is a good source of income for investors as they wait for share prices to re-rate. On top of that, the five-year average dividend pay-out ratio is currently at a low of 31.6% (Table 1), a sign that there is still plenty of room for dividends to increase in the future.

Table 1: Investors Of The Big 4 Banks Will Be Able To Enjoy High Dividend Yields

In addition to the high dividend yields and low pay-out ratio, the quartet also has a stellar track record of consistent dividend payments over the years. Within the past five years, the total free cash flow generated by the big four banks has been substantially higher than what they have paid out in dividends the same year. Given their strong financial position and cash flow generating ability, investors can reasonably expect the high dividend pay-outs to be sustainable (Chart 6).

Chart 6: Strong Free Cash Flow Generation Ensures Sustainable Dividend Payments

Potential Pitfalls To Look Out For

Despite its many investment merits, the Chinese banking sector also has its fair share of potential pitfalls that investors should be aware of. For instance, the synergistic effects of China's domestic deleveraging campaign and an escalating trade war with the US could derail its economic recovery, and the big four banks might still see some pain before the recovery continues.

The majority government ownership of the big four banks in China is a double-edged sword. Owned by the state, it is very unlikely that the government will allow these banks to fail, as they are an essential component of a well-functioning economy. The downside is that the government may use the banks as policy tools, influencing them to perform actions or enact policies that might not be for the benefit of the minority shareholders.

Tremendous Upside Potential

The big four banks are currently trading at an average price-to-book (PB) ratio of 0.71, relatively close to the crisis-level valuations of roughly 0.64 seen in the aftermath of the A-share market crash in late 2015 (Chart 7). We believe that they should be trading at higher valuations, given that the big four banks have come a long way since 2015, with improvements in their asset quality and bottom line.

Chart 7: The Big Four Banks Are Currently Trading Near-Crisis Valuations

The PB ratio is a particularly appropriate measure of intrinsic value for banking stocks, as their assets and liabilities are periodically marked to market. With the exception of Bank of China, we believe that the big four banks should at least be trading at PB ratios of 1.0. We applied a discount to Bank of China (PB ratio of 0.8) to account for its lower return on equity and net interest margins relative to the other three banks.

Based on these assumptions, we project an average upside of close to 40% for the big four banks by end-2019.

Table 2: China's Big Four Banks Have Massive 40% Upside Potential

Participate In The Recovery Of China's Banking Sector Using ETFs

Given the similarities between the big four banks, picking the right one to invest in can potentially be confusing for the inexperienced investor. However, as we feel that the big four banks in particular are going to be the main beneficiaries of the banking sector's recovery, a fitting alternative would be to invest in an ETF that is focused on them.

One suitable ETF is the BMO Hong Kong Banks ETF (HKEX.3143). This ETF is designed to replicate the returns of the NASDAQ Hong Kong Banks Index, which tracks a basket of Chinese bank stocks. Close to half the ETF is weighted towards the big four banks, and the remainder is invested across 12 other Chinese commercial banks, foreign banks listed on the HKEX (e.g. HSBC) as well as Chinese banks incorporated in Hong Kong (Chart 8).

Chart 8: BMO Hong Kong Banks ETF Breakdown

With an annual expense ratio of only 0.45%, this ETF offers investors a low-cost, diversified method to participate in the upside potential from the banking sector's recovery. Stronger loan growth, improving asset quality, recovering net interest margins, high dividend yields and a close to 40% upside potential are factors that make an investment in the big four banks appealing. Investors who wish to capture the massive upside from the recovery of China's banking sector should not wait any longer, as the best time to invest is usually when fear is at its greatest.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.