Top Stock Picker Jain Won’t Touch Chinese Banks on Bad Debt

Top Stock Picker Jain Won’t Touch China Banks
Government-controlled ICBC had a financial leverage ratio, or total assets divided by common equity, of 16.5 at the end of March, according to data compiled by Bloomberg. Photographer: Adam Dean/Bloomberg

Bad loans at Chinese banks will rise to “shockingly high” levels, eroding profits and slowing growth in the world’s second-biggest economy, said Vontobel Asset Management Inc.’s Rajiv Jain, who runs some of this year’s best-performing mutual funds.

China’s local governments are struggling to repay their debt and “frothy” real-estate markets may leave banks exposed to falling prices, Jain said in an Aug. 16 phone interview. While valuations on Chinese banks have dropped to the lowest levels since October 2008, Jain said the shares aren’t cheap enough to buy because the lenders’ leverage is too high and earnings are likely to disappoint investors.

“We have not owned a Chinese bank, and I don’t see owning one any time soon,” said Jain, who oversees about $15 billion, including three funds that beat 99 percent of peers this year, data compiled by Bloomberg show. “If you look at the accounting, I don’t see how anyone could put a penny there.”

The New York-based money manager’s outlook is at odds with equity analysts, who predict gains of about 40 percent in Chinese bank shares during the next 12 months, according to the average of more than 900 estimates compiled by Bloomberg. Industrial & Commercial Bank of China Ltd., China Construction Bank Corp. and Bank of China Ltd. have 101 ratings equivalent to “buy” and zero “sell” recommendations, data compiled by Bloomberg show.

Record Lending

The MSCI China Financials Index dropped 2.1 percent at 3:14 p.m. in Hong Kong. ICBC, the world’s biggest lender by market value, retreated 2.2 percent. China Construction Bank slipped 0.6 percent and Bank of China lost 1 percent.

Chinese banks expanded credit at a record pace in 2009 and 2010, making more than 17.5 trillion yuan ($2.7 trillion) of new loans as the government moved to offset a collapse in exports during the global recession. About a third of local government financing vehicles, used to get around laws prohibiting direct borrowing, don’t have cash flow to service their debt, according to China’s banking regulator.

Non-performing loans may climb to as high as 18 percent in a “stress” case, Moody’s Investors Service said in a July 5 statement. China’s total bad-loan ratio was 1.1 percent at the end of 2010, according to the central bank.

“We feel that the non-performing loans are going to be shockingly high,” said Jain, who declined to give a specific estimate for the amount of bad debt.

Top Performer

Jain’s $1.9 billion Virtus Emerging Markets Opportunities Fund has climbed 15 percent during the past 12 months and rose 0.2 percent this year through Aug. 16, the best performance among emerging-market stock funds with more than $500 million in assets, according to data compiled by Bloomberg. Jain’s Virtus Foreign Opportunities Fund has returned 2.8 percent this year and the Virtus Global Opportunities Fund climbed 4.2 percent, the data show. The MSCI All-Country World Index has retreated 6.9 percent.

MSCI’s China Financials Index has dropped 17 percent this year, sending the gauge to 8.8 times profits and 1.6 times net assets, the lowest levels on a monthly basis since October 2008, according to data compiled by Bloomberg. Shares haven’t fallen enough to compensate investors for the risks associated with high leverage, low lending margins and management incentives that may not maximize returns for shareholders, Jain said.

‘Margin of Safety’

Government-controlled ICBC had a financial leverage ratio, or total assets divided by common equity, of 16.5 at the end of March, according to data compiled by Bloomberg. That compares with an average ratio of 12.7 for banks in the MSCI Emerging Markets Index, the data show. ICBC’s net interest margin was 2.96 percent in the first quarter, compared with 6.1 percent for Itau Unibanco Holding SA, Brazil’s biggest bank by market value, according to data compiled by Bloomberg.

For the Chinese banks, “there’s no margin of safety for us,” Jain said.

Analysts forecast gains for ICBC shares during the next 12 months, with an average price estimate of HK$7.14, compared with the closing price of HK$5.12 in Hong Kong yesterday, according to 25 projections compiled by Bloomberg.

The outlook for Chinese banks is positive for the second half of 2011 because of “solid” earnings, low valuations and the potential for “selective” easing of monetary policy, Sandra Cai, an analyst at Samsung Securities in Hong Kong who has a “buy” rating on ICBC, said in an Aug. 16 report.

Anti-Inflation Measures

Earnings of companies in the MSCI China financials index climbed by an average 32 percent in the first quarter even as the central bank raised its benchmark interest rate three times this year and lifted lenders’ reserve-requirement ratios six times.

The government may have limited room to use fiscal or monetary stimulus to support lending and property markets because of high inflation, according to Jain. China’s consumer prices increased 6.5 percent from a year earlier in July, the fastest pace in three years.

Outside the banking industry, Jain is finding opportunities to invest in China. Baidu Inc., the country’s biggest Internet-search company, was one of the top holdings in the Virtus Emerging Markets Opportunities Fund at the end of July, accounting for about 3.4 percent of assets, according to the fund’s website.

No ‘Meltdown’ Coming

The stock is valued at 32 times analysts’ earnings estimates for next year after climbing 43 percent in New York since December, data compiled by Bloomberg show. That compares with 8.7 times for the MSCI China Index.

The Chinese economy “will slow down, but these companies should still be able to grow,” said Jain. “We are bearish but we don’t feel there’s a meltdown coming.”

Morgan Stanley cut its estimate for Chinese economic growth next year to 8.7 percent from 9 percent, according to an e-mailed note today. Deutsche Bank AG lowered its prediction for this year to 8.9 percent from 9.1 percent in a report yesterday.

Souza Cruz SA, Brazil’s biggest tobacco company, is another holding that Jain says will benefit from rising consumer demand in emerging markets. The shares trade for 15 times 2012 profit estimates, almost double the ratio of 8 for Brazil’s benchmark Bovespa index, data compiled by Bloomberg show.

“We don’t mind paying up a little bit,” said Jain. “We are very bullish on the emerging markets story long term, we just want to find the right spots.”

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