that the economic juggernaut will keep on motoring, whatever the cost for investors in Chinese equities.3
6.4 WHAT LIES BENEATH (FEBRUARY 2014)
The prospectus of a Chinese asset management company reveals troubling exposures
We have long been sceptics of China’s banking system. This view appears rather commonplace nowadays, judging by the languishing valuation mul- tiples for the “Big Four” banks. It seems likely that the very investors who are avoiding China’s banks are the same ones lining up to buy shares in Cinda Asset Management, one of the country’s leading distressed debt investors. They believe that Cinda is a hedge on exposure to China’s precarious finan- cial system. On closer inspection, however, this asset manager is little more than a leveraged play on China’s overblown property market and overin- vested coal industry, propped up by cheap short-term funding provided by the banks from which Cinda acquires its assets.
In the late 1990s, the Chinese financial system was groaning under the weight of non-performing loans (NPLs), caused by lax lending and the spill- over from the Asian crisis. In order to address the issue, the government set up four asset management companies (AMCs) or “bad banks.” Cinda was set up to shepherd the non-performing loans of China Construction Bank and is the first of these state-owned AMCs to come to market. Before last Christmas, Marathon was invited to attend the IPO road show for Cinda. The venue chosen to add some Old World gravitas to the proceedings was the Great Hall of the Worshipful Company of Butchers in the City of London. The event opened with a ten-minute video, complete with American voiceo- ver in deep baritone reminiscent of a Hollywood blockbuster trailer, detail- ing the history of the industry and the prospects of Cinda. From time to time, the audience was treated to library footage of employees collectively high-fiving.
3 From March 2004 to October 2007, the Shanghai Stock Market Composite Index gener- ated a total return of 485 per cent, compounding at annual rate of nearly 100 per cent. After the bubble burst in late 2007, the market declined by 68 per cent. Lately, Chinese stocks have been bubbling again – in the twelve months from June 2014, the Shanghai Composite rose by over 130 per cent. Margin debt in China climbed fivefold over this period to reach $325bn by mid-2015, representing more than 6 per cent of the market’s capitalisation. As China’s economic growth miracle fades, Chinese equities trading on 75 times earnings appear more detached from reality than ever.
In a rare demonstration of cooperation, the regional heads from two competing investment banks took it in turn to highlight the merits of the investment on offer. Chief among these, apparently, was the opportunity for investors to gain exposure to that sexiest of investment classes, distressed assets. It was implied that a position in Cinda would put investors on the right side of the impending explosion of Chinese indebtedness. At first glance, the economics look attractive. Cinda’s return on equity in 2012 was 15.8 per cent, and growth was all but assured because of its dominant position: yours today for a modest multiple of 2.4 times book value. Favourable comparisons were drawn by the bankers between Cinda and one of the most respected of distressed asset investors, Oaktree Capital, itself a cornerstone investor to the offer (that is, if you regard a 0.39 per cent holding as “cornerstone”).
As it turned out, we were not alone in receiving an invitation to meet the company. There were approximately 50 other investors and numerous representatives from the 18 participating underwriters. The excitement was too much for one attendant, who was seen collaring the nearest investment banker to ensure her order was filled – rumour had it that the book was ten times oversubscribed (according to the Wall Street Journal, the retail book ended up 160 times oversubscribed). With eight buys and four holds from the 12 analysts who cover the company and the endorsement of the numer- ous underwriters, the message is clear: only a fool would miss out on this opportunity.
As we often find in China, appearance and reality in Cinda’s case are far apart. From the three years of data disclosed, it seems that the main driver of Cinda’s return on equity has been leverage. The reported return on equity for 2012 was 15.8 per cent, yet the corresponding return on assets was just 3.4 per cent (down from 6.3 per cent in 2010). This implies that the leverage was 4.7 times (up from 4 times in 2010). Successful distressed investors tend to eschew leverage because of the uncertainty in magnitude and timing of returns. They typically have a preference for permanent capital. Being free of debt themselves, distressed debt investors can deploy capital at attractive returns in bad times when leveraged folk have run into trouble. Besides, dis- tressed opportunities generally come with a significant degree of embedded leverage of their own.
A look at the origins of this asset manager’s leverage is instructive. At the end of June 2013, the balance sheet of Cinda showed RMB 220bn in total liabilities. The two biggest and most important line items were RMB 33.5bn provided by the ministry of finance, and RMB 104bn coming from “market- orientated sources.” The cost of funding for the finance ministry liabilities is difficult to determine, but we calculate it at approximately 2.25 per cent
per year. The “market-orientated sources” funding comes from the inter- bank market, in other words the very same banks from which many of the distressed assets originate. This cost of funding appears to be around 4.4 per cent, not the lowest funding rate we have encountered in China by any stretch, but well below the 5.8 per cent prime rate currently being quoted by the largest banks. In short, Cinda’s funding costs are artificially low, possibly unsustainable, and given the company’s high leverage, the impact on profits of any normalisation of interest rates is likely to be significant.
A close reading of the voluminous offering documents also reveals the rather skewed nature of Cinda’s asset book. This comprises two core ele- ments. The first is the distressed debt book, which amounts to RMB 86bn and consists primarily of unpaid receivables that have been acquired from financial and non-financial institutions. A footnote in the prospectus states that: “As at June 30, 2013 the gross amount of our distressed debt assets classified as receivables attributable (i) real estate ... [and] (iv) construction industries represents 60.4 per cent ... and 4.5 per cent of our total distressed assets classified as receivables, respectively.” In other words, two-thirds of Cinda’s distressed book is exposed to Chinese real estate.
The second largest element of Cinda’s book is holdings of debt-to-equity swaps (DES), which amount to RMB 44bn in assets, relating primarily to interests in medium and large state-owned enterprises which have lost their way. Of the top 20 unlisted distressed assets in the portfolio, some 13 are coal mining companies, with the balance being a mix of chemical and manufac- turing businesses. Another footnote reveals that the coal miners account for some 61.5 per cent of Cinda’s DES assets. The document goes on to highlight that “in 2011, the production volume of the aforementioned 21 DES compa- nies in the coal industry in which we directly held equity interests or held equity interest in their subsidiaries totalled 1,605m tonnes of coal, represent- ing 45.6 per cent of national output.”
Even the ugliest of assets purchased at the right price can make for a great investment. And many of Cinda’s assets were acquired at a steep discount to their original face value (often 20 to 30 per cent of the claim amount, according to the company). Yet much of this discount disappears once Cinda’s valuation is taken into account. Put simply, if a company buys assets at 0.3 times book value and an investor buys the same company at 2.4 times (Cinda’s price-to-book), the effect is the same as paying 0.7 times book for the original assets.
We are not criticising the authorities for attempting to restructure China’s overleveraged and underperforming corporate sector. This is neces- sary. Indeed, the creation of asset management companies, like Cinda, and
the tapping of external sources of capital to help deal with the rotten assets represents an encouraging, if rather small, recapitalisation of the China’s credit system. What’s plain wrong is the IPO marketing story that an invest- ment in Cinda is a hedge on problems in China’s financial system. Cinda’s fate is entwined with that of the banks that provide the funding to buy their underperforming assets; after all, Cinda did not spring up to take advantage of the system, it was born of it. We suspect that many investors who rushed to get their Cinda order filled believed they were buying a broadly diversified distressed asset manager. They may wake up one day unhappy to discover they have leveraged long exposures to the Chinese property and coal indus- tries, and to the increasingly fragile Chinese financial system.4
6.5 VALUE TRAPS (SEPTEMBER 2014)
Chinese banks are highly leveraged and poorly positioned in the capital cycleFor the contrarian investor in emerging markets, one sector appears to offer outstanding value. The four largest companies in this group gener- ated an average return on equity of 20 per cent in 2013, and averaged 21 per cent over the previous five years. They have grown their profits at a compound rate of 18 per cent since 2008, achieving last year a respectable 12 per cent increase. Investors who crave liquidity have nothing to fear; the aggregate market capitalisation of these companies is greater than $650bn. Their stocks are unloved and can be purchased in the market for around book value.
The four companies in question are the “Big Four” Chinese banks. Conventional wisdom suggests that the financial system of the People’s Republic is rotten to the core. Yet in the past, Marathon has made decent money in banks in the face of conventional wisdom. The Asian financial crisis, for instance, provided a wonderful opportunity to earn significant returns from cheap financials. Given that Chinese banks are today’s pariahs, might they not provide a similar money-making opportunity?
The short answer is no – at least, in our opinion. A longer answer is best divided into two parts. The first part involves trying to determine the Chinese
4 While perhaps no hedge against a future banking crisis in China, Cinda has so far ful- filled its roadshow promise by trading inversely with the Chinese banks. To wit, from its IPO in February 2014 to the end of the year, Cinda’s share price declined by nearly 20 per cent during which time the MSCI China Banks Index was up 36 per cent. Over the course of 2014, Cinda’s total assets grew by 42 per cent, while implied leverage marched upwards (to 5.1 times).
banks’ true profitability, and the second to where exactly these banks stand in the capital cycle. Let’s start by deconstructing the banks’ profitability. Take the largest of them, the Industrial and Commercial Bank of China (ICBC), which boasts a return on equity of 20.8 per cent. This derives from a return on assets of 1.4 per cent, magnified nearly 15 times by leverage. The first ques- tion is whether credit risk – that is, provisions for non-performing loans on its books – has been adequately accounted. Chart 6.2 compares the loan growth and the cost of risk over the last decade for ICBC and Bank of America, one of the largest US banks. You will notice that ICBC’s credit costs have been con- sistently low over the past few years, during which loan growth has remained at elevated levels. The left-hand chart reveals that Bank of America had simi- larly low credit costs and strong loan growth in the years leading up to the Lehman crisis, when the proverbial chickens came home to roost.
A bank’s reported return on capital is very sensitive to credit costs. For instance, if ICBC’s cost of risk were to rise to an unremarkable 1 per cent, its return on equity would drop by nearly a fifth, from 20.6 per cent to 16.8 per cent. When considering a bank’s true profitability it’s also necessary to normalise the level of leverage. At ICBC, every renminbi of equity supports nearly RMB 15 of debt. Yet just as leverage magnifies profits, it can also magnify losses. The average level of leverage for an emerging market bank is around 10 times. Bank of America’s balance sheet is leveraged by the same amount. Assuming credit costs of 1 per cent of total loans and leverage of 10 times, ICBC’s return on equity would fall to 11.3 per cent. This figure seems to us is closer to ICBC’s sustainable profitability. We reach this conclusion