Readers of previous articles will know I am not particularly impressed with US equities as an asset class - at least not for someone who invests primarily for dividend income. Payout ratios at US corporations (currently at 30 year lows) are the primary cause, but other factors such as share buybacks, M&A and general hoarding of cash are also contributing factors. Management at listed companies in Europe, Asia (with the exception of Japan), Australia and South America seem more committed to returning earnings to stockholders in the form of cash dividends, which is why I tend to make most of my investments outside the US.
Fortunately, as emerging markets approach maturity, the number of countries where one can invest securely is increasing. One of these markets is of course China. And a good proxy for "China Inc" is its bank sector, and it's a highly profitable sector. According to Reuters, Chinese banks accounted for 29% of global bank profits in 2011. The biggest four lenders account for half of China's loans. In particular, I like Industrial and Commercial Bank of China - or ICBC (OTCPK:IDCBY). ICBC is China's largest bank. It is also the world's largest by market cap. Its size has not been a hindrance in its ability to grow its business. ICBC's EPS increased 21.83% last year, with Q3 results increasing 17% to a record $9.9 billion, comfortably beating analyst estimates. The quality of these earnings is impressive in light of a Chinese economy that continues to decelerate for the seventh quarter in a row. In fact, it is pessimism about the growth in the Chinese economy which has pushed ICBC into bargain territory, with all four lenders underperforming their benchmark Hang Seng Index this year.
The current ratios plus comparative 5 year data are what speak most highly about ICBC.
P/E Ratio (TTM)
P/E High - Last 5 Yrs
P/E Low - Last 5 Yrs
Price to Book (MRQ)
Price to Tangible Book (MRQ)
Dividend Yield - 5 Year Avg.
Dividend Yield - 5 Year Growth Rate
Sales 5 Yr. Growth Rate
EPS - 5 Yr. Growth Rate
By any valuation metric this stock is cheap. Chinese lenders are trading close to record-low valuations - approaching parity with book and tangible book, thus providing the "margin of safety" favored by Benjamin Graham. This despite rallying in September on the back of 3rd round QE easing in the US, and an announcement by the China sovereign wealth fund that they will buy into the sector. Perversely, the current mindset around the whole China play isn't a fear that the Chinese economy is contracting or approaching recession territory. The fear is that it isn't expanding as quickly. But as Victor Wang, a Hong Kong-based analyst at Macquarie Capital Securities Ltd, commented after release of the Q3 numbers: "The third-quarter results season tells us we do not need to be super bearish for these money-making machines. Chinese lenders "have strong ability to manage their loan portfolio and sticky pricing power." ICBC has posted growth of at least 10 percent each year since its 2006 IPO.
In my opinion the opportunity play with ICBC is that current valuations are very short term and only reflect one side of its loan book, i.e. "China Inc." Not that there aren't grounds for a certain degree of pessimism here. Profits at industrial companies declined each month in the five months through August. The issue is that the scare is overdone. Profits in Chinese industry actually rebounded 7.8% in September. Regardless of China's industrial sector, its loan book isn't just about industrial exporters. It is well balanced. Net interest income at ICBC rose 16 percent to $17 billion in the third quarter, reflecting strong consumer demand, while income from fee-based services such as credit cards increased 1.5 percent to $3.95 billion. The reason why I singled out ICBC over the other big four Chinese lenders is not its size, but the diversification in its earnings streams. The quality of its earnings mix is superior to the other three.
NPLs (non-performing loans), a worry at Chinese banks in recent months, eased at ICBC from 3 months earlier, providing possible evidence that China's economic slowdown may have bottomed out. The Chinese government has also added stimulus by fast tracking approvals of investment projects, lowering interest rates and adding tax concessions for exporters. Even so there is a time lag before the effects will start meaningfully filtering through to NPL books. Even so, as of Nov 7th, Moody's affirmed the long-term/short-term deposit ratings of A1/P-1 for China's big four banks.
For me as a dividend investor the metric that stands out is EPS, which is increasing at a faster clip than dividend increases. This has come at the expense of the payout ratio which has declined each year from a high of 54.50 in 2007. Still, the stock's CY is almost 5%. With a current payout ratio of only 34%, I consider the 5% yield as safe. Again there is a margin of safety, as management has plenty of room to increase the dividend - even if earnings decline.
And the Bad News?
Ironically, the market isn't pricing any political risk into this stock - only its short term economic outlook. In my opinion there is political risk with this stock. The Chinese state owns 71% of ICBC. It has majority stakes in all of the four major lenders via its Sovereign Wealth Fund, Huijin Investment Co. The other major stakeholders have been western banks, BAC, Goldman and HSBC. Having a nation state (which isn't a true democracy) as a majority shareholder does present potential if not actual risk.
If any conflict of interest arises they are free to act in their own interests - political or otherwise, with complete disregard for the interests of minority shareholders. But before red blooded American investors reel in horror at the idea of state control or intervention in private enterprise, we should remember that banking is financial infrastructure, and capitalism cannot function without it. Hence TARP, which was no more than the socialization of private debt. Some UK banks still remained nationalised 4 years after the GFC. Sweden also underwent its own banking crisis in the early 90s, requiring state intervention and partial nationalization. Although reduced, the Swedish state still holds a 13% ownership in Nordea, the largest Nordic lender. Swedish banks are today rated as some of the world's safest. Although a full discussion of the risks and merits of state intervention/ownership is beyond the scope of this article, readers should do their due diligence and understand what it is they are buying.
The Small Print
ICBC trades as an ADR. Be warned though, liquidity isn't that great, with average daily volume at around 60,000 shares. Wider bid/ask spreads can push up your transaction costs. Better you trade it in Hong Kong, where average daily volume is 250 million shares. Check with your broker regarding custodian fees for holding Hong Kong paper. Although the underlying earnings are in Yuan, the dividend is paid in HKD. Withholding tax on Chinese dividend income for investors with a double tax treaty with China (includes US) is 10%. Neither currency has much exchange risk. The Yuan is not a free floating currency, and the HKD is pegged to the dollar, moving in a narrow range.