Source: S&P Capital IQ.
Net Loan Growth (LHS) Bad debt provisions (RHS) 0.0% 0.2% 0.4% 0.6% 0.8% 1.0% 1.2% –10% –5% 0% 5% 10% 15% 20% 25% 30% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% –10% 0% 10% 20% 30% 40% 50% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
without factoring in concerns about the integrity of the bank’s balance sheet or systemic threats to China’s financial system.
It’s not just that credit costs are low and leverage is high for China banks. They also seem poorly positioned in the capital cycle. In the textbook example of a capital cycle, new capital is attracted into sectors with outsized profits. Eventually, this influx of capital causes capacity to overshoot, which hurts industry profitability and shareholder returns. This process is most marked in commodity businesses, whose products are undifferentiated. The opportunity to make really good investments tends to occur only after a turn in the cycle; that is, when capital begins to exit.
Given that credit is a commodity, capital cycle analysis is as relevant for banks as it is for any other commodity business. There are, however, some differences. Because credit has no physical constraints, its increase is limited only by the amount of equity a bank can accumulate and the amount of leverage it can assume. This makes it easier for management to get carried away in the upward phase of the cycle. When the banking cycle turns, there needs to be a catch-up charge for the unrecognised sins of the past – that is, a spike in credit costs. Capacity also needs to exit through deleveraging; this comes in the form of shrinking balance sheets and mergers.
In the case of the Chinese banks, these symptoms have yet to present themselves, which means that from an investor’s perspective they are not yet in the right part of the capital cycle. Credit costs have remained eerily low and although we have seen some capital-raising, this has been done to sustain growth rather than to deleverage. How this plays out is difficult to determine. China’s credit denouement may occur in a rapid (and cathartic) fashion in the mode of the Asian crisis, or be more drawn out, Japanese-style – but happen it must.
6.6 DEVIL TAKE THE HINDMOST (MAY 2015)
Chinese equities are showing every sign of speculative excessChinese stocks have been building up steam over the last year. In the twelve months to April, the mainland Chinese equity markets have risen by 120 per cent. Market commentators appear reluctant to call time on the Chinese bubble. A recent Financial Times editorial opined that even though “Chinese stocks are plainly overvalued ... [they] can go higher.” That’s indisputable. Goldman Sachs pronounces: the market is “certainly getting frothy” amid “very frenetic retail activity,” but “is it a bubble that will crash the sys- tem? The answer is not yet.” Gavekal, a Hong Kong-based strategy outfit,
warns that “wallflower investors who continue to hang back may soon be in danger of missing the party.” Some parties, however, leave rather heavy hangovers.
On the face of it, China’s equities should be of considerable interest to Marathon. Some industries appear to have arrived at a low point in their capital cycle. Equity valuations – at least a few months ago – appeared rea- sonable. Beijing had announced its intention to tackle massive industrial excess capacity. All this should make for a sympathetic starting point from an investor’s perspective. Yet valuations are not as compelling as they seem (lowly aggregate market valuations are influenced heavily by the troubled banks). Furthermore, the legacy of China’s massive overinvestment is severe and likely to persist.
The Shanghai index is now valued at 21.7 times earnings; excluding banks, however, this multiple rises to 37 times earnings. The Shenzhen exchange, which is not weighed down by the banks and has more exposure to the frothy technology sector, is currently valued at over 57 times earnings. That three of the four largest companies on the Shenzhen exchange are retail stock brokers is troubling.
The equity market’s latest rise has coincided with (yet) another substan- tial monetary easing policy – this time known as “pledged supplementary lending,” which, commencing in the early summer of 2014, has allowed financial institutions access to RMB 1tn in short- to medium-term liquid- ity. Following the implementation of these monetary operations, the seven- day repo rate declined from over 5 per cent to 3 per cent by last September. Around the same time, the government cut trading fees, increased the number of brokerage accounts allowed per person from one to 20 (who could need so many?) and relaxed restrictions on margin lending. Beijing appears to have deliberately inflated this bubble.
The state media also began providing explicit support by publish- ing numerous articles which hyped the virtues of stock market investing. The results of these interventions are hidden in plain sight. Take the case of Beijing Baofeng Technology, an online video services provider. As of mid-May, the company had been listed for 39 days on the Shenzhen Stock Exchange. For 36 of those days, its shares have risen by the daily allowable limit of 10 per cent. Through the magic of compounding, the stock is up by over 2,500 per cent in a little over a month and a half. The company, with just $3m in operating profits, now boasts a hefty $4bn market capitalization. Beijing Baofeng is but one of the 225 IPOs launched this year – 223 of those were limit-up on their first day of trading, with the mean performance since IPO being over 400 per cent.
Margin lending is one of the fastest growing areas for retail brokers. Lending volumes are up 80 per cent so far this year and have more than quintupled since the beginning of 2014. Margin lending was first permit- ted in China in 2010 and has gone on to fund over 8 per cent of the free- float adjusted market capitalization – by contrast, margin lending on the Big Board is around 2 per cent of market value. Readers of J.K. Galbraith’s
The Great Crash may recall his view that margin loans were a key compo-
nent of the 1929 crash, after reaching 10 per cent of market capitalization. Contemporary speculators in Chinese equities are even more leveraged than their Jazz Age forerunners. The French bank BNP believes that around 20 per cent of incremental volume traded on the Shanghai Stock Exchange is funded with margin loans.
Some of this liquidity has found its way to the Hong Kong Stock Exchange, thanks to the “Stock Connect” program, which allows mainland investors to access Chinese shares traded in the former British territory. Chinese stocks listed in Hong Kong have been trading at an average dis- count of 30 per cent to their mainland equivalents. The bulls hope to profit from a narrowing of this discount as Hong Kong shares rise to Shanghai valuations.
Shanghai Electric, a large industrial company with listings in Shanghai and Hong Kong, is a good example of the current market madness. In China, the company has an implied market capitalisation of $41bn, a price-earnings multiple of almost 100 times, and a price-to-book multiple of over six times (for a 10 per cent RoE). In Hong Kong, investors are valuing the same com- pany at $13.3bn of implied market capitalisation, with a price-earnings mul- tiple of 33 times and a price-to-book multiple of 2.3 times. Compared with the China price, the Hong Kong line may look a bargain. But in our view, both valuations are unjustifiable.
Investors appear so transfixed by the relative cheapness in Hong Kong that they are paying no attention to absolute value. The argument that Hong Kong valuations should move upwards to the bubble levels found in Shanghai and not vice versa may convince some of Gavekal’s “wallflowers.” But not us. Marathon is more inclined to trust the stock prices determined by worldly (if occasionally excitable) Hong Kong investors over their mainland coun- terparts, whose money, trapped within the People’s Republic by capital con- trols, fuels one speculative excess after another.5
5 Between the date of this article and mid-September 2015, the Shanghai Stock Exchange Composite Index declined by 32 per cent. Over the same period, Beijing Baofeng Technology declined by 69 per cent.