- Bank of China Limited is severely undervalued, despite very good financial results compared to major U.S. banks like Wells Fargo and Bank of America.
- The U.S. stock market appears fairly valued or even overpriced now, while the Chinese market is one of the cheapest in the world: investing in China makes sense.
- On a fundamental level, Bank of China is a buy.
I believe that Bank of China (OTCPK:BACHY) has major catastrophes priced in. As such, it seems to be a good time to start (or add to) a position in this stock, despite the price being up about 20% from a recent bottom reached in March. Indeed, on a fundamental level BACHY remains severely undervalued. Here I present my investment thesis for buying BACHY, and I compare the financial results and market valuation of this bank with two well-known U.S. banks: Wells Fargo Bank (NYSE:WFC), which I think is fully valued or even over-valued, with a price-to-book ratio P/B of 1.65 (data from the Bloomberg website as of August 19, 2014), and Bank of America (NYSE:BAC), which appears much cheaper with a P/B of only 0.73.
Bank of China Limited is the fourth largest bank in China by assets, and the 11th in the world (as of December 31, 2013). It is also the most global of the major Chinese banks, with a presence in 38 countries. The annual financial report for 2013 shows that "only" 82.6% of its operating income came from mainland China. The rest resulted from operations in Hong-Kong, Macau, and Taiwan (14.2%), and from the rest of the world (3.37%).
For the rest of this article, all numbers for WFC will come from its 2nd quarter financial statement (otherwise stated), and the numbers for BAC will come from the following 2nd quarter earnings release. The numbers for BACHY will also come from the 2nd quarter of 2014 announcement, that was just released on August 19.
First Half of 2014 Results of Bank of China
Bank of China performed quite well last year: during the last quarter of 2013, its profits before income tax showed a healthy 13.4% year-on-year (y-o-y) increase. The first half of 2014 results showed a similar rise in profits before tax by 10.6% y-o-y. In contrast, Bank of America saw its most recent profits before income tax drop y-o-y by 71.7% and Wells Fargo saw its profits before tax (and provisions) decrease y-o-y by 2.75%. Clearly, Bank of China outperformed in term of income growth.
A good 66.7% of BACHY's operating income comes from the interest spread, while 33.3% comes from non-interest income (fees and commissions mainly): this is a healthy revenue diversification. Wells Fargo had an almost perfect revenues separation: 51% of its revenues came from net interest income, and 49% from non-interest income. Similarly, Bank of America derived 53% from non-interest, and 47% from net interest. Bank of China is not nearly as diversified as these two U.S. banks but there is no risky income concentration.
A soft point is the common equity tier 1 capital ratio of BACHY, which stands at 9.36% at the end of the 2nd quarter: this has decreased by 0.33 percentage points compared to December 31, 2013. This is still a decent, but clearly not outstanding, number (and with the caveat that this number is, I believe, not in compliance with Basel III rules): the bank may be appropriately capitalized, but I would feel more comfortable with a ratio larger than 10%. Wells Fargo has a significantly higher ratio at 11.31% (2nd quarter 2014, Basel III rules), while Bank of America reached 12%: U.S. banks are, generally speaking, better capitalized than most foreign banks.
Another so-so metric is the net interest margin [NIM] of Bank of China, which was a rather low 2.27% at the end of the second quarter (and slightly lower than the 2.29% of March 31, 2014). However, this represents a year-on-year increase of 0.04 percentage points. A very positive point is that this NIM has been slowly increasing for the past few years. If the trend continues, that bodes well for BACHY's revenues. Still, this NIM remains low compared to the one of Wells Fargo, which stands at 3.15% at the end of the 2nd quarter of 2014, but shows a worrisome negative trend (year-on-year decrease by 0.32 percentage points). Bank of America had a NIM of 2.26% at the end of the last quarter, comparable with Bank of China.
On the plus side for BACHY, the efficiency ratio defined as non-interest expenses divided by total revenues is low (the lower the better) at 36.6%, while it was at 42% at the end of 1st quarter: this compares very favorably to the 57.9% of Wells Fargo. Moreover BACHY's ratio has decreased by 3.3 percentage points y-o-y. Bank of America, on the other hand, had a pretty bad efficiency ratio of 91.17% at the end of the 2nd quarter. Here, I did not use the cost-to-income ratio provided in the financial report of Bank of China, because it is computed "under domestic regulations" which are different from U.S. standards.
Another positive point is that only 1.02% of the loans of Bank of China were non-performing at the end of the 2nd quarter, which compares advantageously with the 1.13% of WFC (well, with the usual caveat that the non performing loans are defined in a different way in China than in the U.S.). Similarly, Bank of America had 1.70% of its loans non-performing at the end of the 2nd quarter. Unfortunately, the ratio has increased for Bank of China compared to the end of the 1st quarter, when it stood at 0.98%, and to December 31, 2013, when it stood at 0.96%. A major risk for the Chinese banking system right now is an increase in impaired/non-performing loans: the rapid credit expansion that the Chinese government favored lead to lower quality loans.
The loan to deposit ratio of BACHY was 72.29% (end of 2nd quarter), while it was 74.1% for WFC and 81.5% for BAC.
Finally, BACHY's return on assets (ROA) was a decent 1.27% at the end of the 2nd quarter (vs. 1.47% for WFC and 0.32% for BAC for the trailing-twelve-months), and the return on equity (ROE) was good at 18.57% (vs. 13.40% for WFC and a very low 3.15% for BAC).
These selected metrics (I listed some of the ones I believe are important) provide a rather positive image of Bank of China: it is a profitable company that seems to be efficiently managed and whose revenues are growing at a good pace, much faster than Bank of America and Wells Fargo. It also has some amount of geographic diversification. Unfortunately, the amount of bad loans is also increasing, but for now remains manageable.
Current Market Valuation
Despite these positive financial results, the P/B ratio of BACHY is low at 0.844 (based on net asset value on June 30, 2014) for the H shares (those accessible to foreigners and traded on the Hong-Kong stock exchange). For comparison, Wells Fargo has a P/B of 1.65 (Bloomberg website): that's almost twice as much. The P/E ratio of BACHY is also an unbelievably low 5.20 trailing-twelve-months [ttm]. WFC, on the other hand, trades at a P/E of 12.56 (ttm, again according to Bloomberg). This is a much higher valuation than BACHY. Bank of America's P/B ratio is lower than BACHY's at 0.73, but its P/E ratio is much higher at 10.13 ttm.
Finally, the dividend yield of Bank of China currently stands at 5.64% (with the 2014 annual dividend of 0.66699 USD), compared to a meager 2.75% for Wells Fargo and 1.28% for Bank of America.
All these numbers point toward the same conclusion: we are looking at an undervalued bank that is trading at a rather large discount to some of its American peers. To me, this spells opportunity for value investors.
So, why is BACHY so cheap?
The reasons are well known, and are pretty much the same for all Chinese stocks across the board (look at how dirt cheap Xinyuan Real Estates (NYSE:XIN) currently is).
First, unlike WFC and BAC, it is a Chinese stock: there is always the fear that they cook the book. Enough investors have been burnt by fraudulent accounting (a more severe form of creative accounting) that pretty much all of the Chinese stocks are regarded with suspicion. And even if they don't cook the book, they do define things differently: non performing loans, tier 1 capital, cost-to-income ratio, etc. are all defined in a different way than what is done in the U.S., making apple-to-apple comparison more difficult.
Second, the majority shareholder of Bank of China is the Chinese government: Central Huijin Investment, the investing arm of the Chinese state, owns 67.72% of the shares. The Chinese government is not in the habit of acting in the shareholder's best interest, and may even take political decisions that outright hurt the company.
Third, and probably more importantly, it is widely known that the Chinese economy is at a crossroads and that there is a significant risk of a financial downturn. The Chinese government wants to boost domestic consumption and to reduce the country's reliance on investment, which means a structural change in the economy. This, and the global economic slowdown, resulted in a reduction in the GDP growth. The government recently implemented targeted stimuli in the hope of producing a soft landing of the economy, rather than the widely heralded hard landing. Beijing targets a 7.5% growth this year, instead of the 10% or so we used to have in the recent past. But as always, it is difficult to know what the actual GDP growth is, as it is easily manipulated by state agencies. There is also a property bubble, that could explode any time, and the amount of corporate debt has reached worrisome levels in the country. Moreover, the amount of bad loans reported by the Chinese banks in general is thought to be underestimated, and clearly these banks pose a systemic risk. In short, the Chinese economy is in turmoil right now, and things aren't improving. However, as always, the point is not whether the Chinese economy is bad, but whether this is already priced in: news about the Chinese GDP hurting have been around for quite a while, and I believe this is pretty much priced into the shares. As I wrote in the title, BACHY is already priced in for a major catastrophe. Therefore, I see more upside than downside.
I believe that Chinese markets are so cheap right now that a lot of bad news is already priced in and that it is a good time to invest in China in general, despite the market rise of these past few months. I further believe, as a contrarian, that the Chinese banking system has been so criticized, is so feared, and is so undervalued that it makes sense to go long now. The risks are real, so it's probably better, as usual, to start with a small position. Of the four major Chinese banks, I like Bank of China the most, due to its global presence. I think that Bank of China is deeply undervalued and has decent growth prospects. I don't have a price target, but I enjoyed the analysis of Morningstar that gave, back in May, a fair value 14.11% higher than the price on August 19 (again for the H shares. The A shares, listed in Shanghai but not available to foreigners, are even cheaper).
Editor's Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks.