Cheapest-Ever Chinese Banks Aren't Cheap Enough

Updated on
  • Shares of Big Four lenders trade at record-low valuations
  • Dividend payouts seen unsustainable as banks preserve capital

It’s going to take more than record-low valuations to convince David Herro that now’s the time to buy shares of Chinese banks.

The manager of about $30 billion at Harris Associates LP, who’s been scouring global markets for beaten-down stocks during this year’s selloff, says lenders from Asia’s biggest economy aren’t cheap enough after they sank to all-time lows relative to net assets, earnings and dividends this month.

While such gauges of value would normally be irresistible to bargain-hunting investors, these aren’t normal times for Chinese banks. Bad debts are surging after the economy slowed to its weakest pace in a quarter century last year, and analysts say the problem will only get worse after banks ramped up lending to record levels in January. As loan losses erode capital buffers, shareholders face the unpleasant prospect of lower dividend payouts, dilution from the issuance of new equity, or a combination of both.

“We still have concerns about credit quality,” Herro, one of Morningstar Inc.’s money managers of the decade in 2010, said in an e-mailed reply to questions. His flagship Oakmark International Fund, which had its biggest weighting in financial shares and allocated more than a quarter of its money to Asian stocks at the end of 2015, has been avoiding Chinese banks for at least five years, according to data compiled by Bloomberg.

Big Four

Slumping bank stocks are by no means unique to Asia’s largest economy. The industry is getting pummeled around the world as falling interest rates narrow lenders’ profit margins and a slowing global economy hurts revenue. China stands out, though, for the severity of its selloff.

Shares of the nation’s “Big Four” lenders -- Industrial & Commercial Bank of China Ltd., Bank of China Ltd., China Construction Bank Corp. and Agricultural Bank of China -- sank to an average 0.64 times net assets on Hong Kong’s bourse earlier this month, the lowest level since AgBank listed in 2010. That’s a 24 percent discount relative to MSCI Inc.’s global index of financial stocks, versus 10 percent as recently as April. Price-to-earnings ratios in China are 80 percent lower than international peers, while the Big Four have an average dividend yield of 8.4 percent, twice as high as the global index.

QuickTake China's Pain Points

Bears say Chinese banks are cheap for good reasons, chief among them the prospect for a surge in bad debt. Government figures show nonperforming loans jumped to a nine-year high of 1.27 trillion yuan ($195 billion) in December, or 1.67 percent of the total, a level that some analysts say understates the true scale of the problem. New loans swelled to a record 2.51 trillion yuan in January, fueling concern that banks are throwing good money after bad to keep struggling borrowers afloat.

Bass Bet

While opinions differ on the amount of troubled loans, Hayman Capital Management’s Kyle Bass, a hedge fund manager who grabbed headlines this year with his bearish views on China, has warned that the bad-debt ratio may reach 10 percent. Analysts at China International Capital Corp., who have a more sanguine view on the economy, are predicting a level of 8.1 percent.

“As a medium- to long-term investor, I wouldn’t want to own the banks,” said John-Paul Smith, the U.K.-based founder of research firm Ecstrat, whose warnings about the dangers of investing in Chinese lenders since at least 2011 have foreshadowed a $104 billion slump in the combined market value of the Big Four. “Dividend yields at this level are clearly not sustainable -- the market is rightly discounting a significant level of asset impairment.”

Even if pessimists are overestimating the potential for loan losses, analysts still see dismal growth prospects for Chinese banks as interest rates fall and Internet-based providers of financial services, including Alibaba Group Holding Ltd., invade lenders’ turf. Earnings per share at the Big Four will probably show close to zero growth this year after slipping an average 1.2 percent in 2015, according to estimates compiled by Bloomberg.

Too Bearish

“There’s no earnings growth,” said Caroline Maurer, the Hong Kong-based head of greater China equities at BNP Paribas Investment Partners, which oversees about $604 billion and has an underweight position in Chinese banks. “I want to buy something with more clarity on growth.”

For Chen Shujin, an analyst at DBS Vickers Hong Kong Ltd., the slump in bank shares is handing investors an opportunity to jump in. She says dividend yields are appealing even if the banks cut their payout ratios -- a measure of cash distributions as a proportion of earnings -- to a range of 25-30 percent from 33-35 percent.

The government could also help shore up the industry by financing purchases of nonperforming loans or compelling other state-run firms to recapitalize banks at inflated share prices, according to BNP Paribas SA analyst Judy Zhang, who has buy ratings on all of the Big Four lenders. In one sign that policy makers are moving to tackle the bad-debt problem, China plans allow banks to issue up to 50 billion yuan of asset-backed securities to remove NPLs from their balance sheets, people familiar with the matter said on Thursday.

ICBC was unchanged in Hong Kong trading at 10:42 a.m. local time on Friday, while the other three big lenders rose about 1 percent. The Hang Seng China Enterprises Index increased 1.8 percent.

“It’s a good time to buy,” Chen said in an interview. “Investors, especially those from Europe and the U.S., are too negative.”

One of those overseas money managers, Claude Tiramani at LA Banque Postale Asset Management in Paris, is finding more attractive opportunities in U.S. and European bank shares after prices tumbled this year. Those lenders have “cleaner” balance sheets than their Chinese peers and offer more transparency to investors, he said.

“I’m much less inclined to invest into China banks,” said Tiramani, who helps oversee the equivalent of $22 billion and sees property and consumer stocks as better ways to invest in the country. “Sooner or later, they will have to cut dividends and clean up their balance sheets to absorb NPLs.”

— With assistance by Tom Redmond, Jun Luo, and Kana Nishizawa

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