The most commonly used traditional valuation approaches are DCF model and PE comparables, and each has its own intrinsic flaws. In DCF method, analysts are required to make assumptions on a firm's initial growth rate; terminal growth rate and in interest rate trend. The outcome share price is also highly sensitive to those assumptions. Analysts generally will adjust those parameters until the result is within a reasonable range. I always doubt the usefulness of DCF model as there are so much guesswork involved.
In using PE comparables, market PEs are affected by supply/demand of the stock and investor's sentiment about a particular sector. Hot sectors (like PRC companies recently) are unavoidably overpriced.
As we all know, stock price is a reflection of investor's view about a company's future earning power, historical performance data hence would be of little value in forecasting a company's future. In most cases this is absolutely correct, however, as we know China is an interesting country and counter-intuitive things do happen.
For the three listed Chinese state-owned banks, I believe their historical performances do have predictive power to their future performances. My rationale is based on the following three China specific factors:
The Duty To Support Government Policy
Chinese state-owned banks [Industrial & Commercial Bank of China [ICBC], Bank of China [BOC], China Construction Bank [CCB], Agricultural Bank of China [ABC]] carried the role as China's policy banks. By 'policy bank' it means their activities are more of political rather than commercial in nature. For example, if the government's policy is to support the agricultural sector, banks will offer policy lending to farmers and companies within the sector without proper consideration of commercial risk. That explains the astronomical size of NPL (Non Performing Loan) inherited with the banks before their listing. Although they are now listed (in Hong Kong as H-share) and are supposed to operate in a more business oriented fashion, I believe their obligations to support government policy still remain. That is why foreign investors are still restricted to own no more than 19.9% of share in those stated owned banks so that government can still maintain control of the board and management.
Management and Company Culture
Even though the banks have invited foreign financial institutions as strategic investors as part of the listing process, they are only minority shareholders and their capability to influence the management are in doubt. Though banks such as China Construction Bank and Bank of China had replaced their senior management teams and recruited professional management from overseas, in those huge state-owned enterprises with long history, it's easier said than done to change the company culture to a truly professionally run organization.
Tale Of Two Markets
Lastly, banks are having their hands tied in improving credit risk management due to the immature credit market as opposed to the rapid developing equity market in Shanghai and Shenzhen. The introduction of SHIBOR (Shanghai Interbank Offer Rate) last month is a significant milestone in China's credit market, however, it will still take a long time before instruments such as interest rate swap and credit default swap [CDS] are available and become popular. Those instruments are essential to the securitization and efficient transfer of banks' credit risks to market participants.
Because of the above reasons, I believe there be no significant changes in the banks' future relative performance comparing to their past and hence historical data can offer certain amount of predictive power.
As the biggest problem with all banks is non performing loan [NPL], I would use NPL as a major parameter to rank the banks' historical performance.
As can be seen from the table, in 2002 (which was the year prior to the government's capital injection to package the banks for listing) China Construction Bank's non-performing loan ratio (22%) is the lowest among the three, while that of ICBC is the worst. To take into account of the different branch network size, I created the ratio [(nonperforming loan %) / (number of branch)] and that will give us a feeling how worst is the situation per branch per bank. With this ratio Bank of China is the worst performing bank.
Now let's look at their profitability. As the tax rates of the banks also differ, I've used pre-tax profit as comparison. (It is expected that in 2008 the Chinese Government will reform the tax policy and all banks will have the same tax rate.) Similarly I computed the per branch profit contribution per bank. Again China Construction Bank performed the best.
From the above analysis, CCB is historically the best performing bank in terms of both credit management capability and profitability, while Bank of China is the worst.
We also noticed that CCB was also the first stated owned bank listed overseas. This is by no means a coincident. The Chinese leaders have to ensure the success of the first listed so as to set a stage for the others, as such it is reasonable to assume that the leaders should have selected the best bank to be the pioneer. Who else would have better insider information than the Chinese leaders? It would be your decision to bet with the Chinese leaders' choice or analysts' DCF models.
Evan though there is no direct channel to invest in CCB, we can still indirectly invest in ETFs with Chinese exposures. Before we make our investment to those ETFs, it would be wise to take a look at their top 10 holding first.
Tuesday, February 6, 2007