Are Chinese Banks Dead?

Investors have been shying away from the stocks of Chinese banks this year, because of uncertainty surrounding the Chinese economy and government restrictions on the banks’ ability to lend.

China’s “Big Four” banks recently reported weaker-than-expected first-quarter 2012 earnings, with the sector facing growing pressure from slowing loan growth. Although a slowing economy is one of the culprits, most of the slowdown in loans is the direct consequence of government directives to cool down financing for infrastructure-related projects, to curb speculative excesses.

These government strictures should be placed in context. The Chinese leadership is eager to see projects already underway successfully reach completion, rather than opening the door to more construction starts. The central government also wants to make sure that local officials aren’t simply pumping money into dubious projects for the sake of reaching their public works quotas.

Pessimism about the prospects for Chinese banks, especially the Big Four, has pushed down their stock prices. However, the Chinese economy is expected to put in a respectable performance this year, which should lift their shares. Although not at rock bottom, their current valuations still offer good entry points for investors.

For the first quarter of the year, banks’ net profits were up around 17 percent, still a good number given the uncertainty surrounding them. There’s value in Chinese bank shares and investors should have some money in them.

Our favorite remains China Construction Bank, or CCB (Hong Kong: 0939), the second-largest commercial bank in China based on assets, loans, deposits and revenue, with total assets of more than USD1.6 trillion. The bank was established in 1954 with the original mandate of funding public works projects such as roads and bridges.

CCB is now a full-service financial institution with a significant retail network throughout China. It employs more than 310,000 people and has 13,500 branches. It was the first Big Four mainland bank to be listed on the Hong Kong Stock Exchange six years ago.

CCB reported first-quarter 2012 earnings of USD8 billion, an increase of around nine percent. Fee income was up by 13 percent, while non-performing loans were lower by 0.3 percent on a quarterly basis. Core capital ratio improved once again to 11.02 percent, the highest among its peers.

CCB is one of the best-run banks in China, with a well-diversified revenue mix and an ability to successfully control costs. The bank has generally managed its business prudently. For example, when loan growth was skyrocketing in 2009, CCB kept its loan growth at 27 percent, compared to 35 percent to 50 percent for the sector.

The bank also was one of the first to lower its loan exposure to real estate and infrastructure-related sectors to manageable levels. Loans to property developers represent 7 percent of loans, down from 10 percent in 2007. The transportation sector receives 11 percent of CCB’s loans and the power and utilities sectors account for 12 percent of loans. The bank’s deposit mix is skewed toward demand deposits (i.e. checking), which represent about 54 percent of the total.

Although the sector still faces risks, Chinese banks have entered 2012 in a far stronger position than many investors recognize. CCB boasts a return on equity of around 23 percent and its shares trade at about 1.5 times book value and about 7 times earnings—undemanding valuations in light of the lender’s solid business fundamentals. The stock also has a 4.7 percent dividend yield, which can cushion against downside moves.