Bank on the banks,

SCMP, South China Morning Post, 9 Nov. 2013.

By Joe Zhang *

Every investor likes to think that he or she is a contrarian. The truth is that they are anything but.

A vast majority of investors go with the crowd, and why shouldn't they? They have received the same education, and so too have their end-investors. Research analysts are too scared about losing the confidence of fund managers, so they mostly write the same research.

The way I see it, the ultimate contrarian trade at present is the buying of mainland bank stocks.

These banks and their stocks might seem toxic to outsiders. Everyone in the investment community is making the same complaints: the mainland economy will continue to slow; the banks' non-performing loans will soar; unregulated shadow banking is a time bomb; and local government debts are about to explode.

However, to me at least, the mainland banks are extremely attractive.

Let's start with the obvious valuation metrics: they trade around book values similar to their global peers that have been ravaged by the recent subprime crisis, although the mainland banks' returns on equity (about 20 per cent) are double that of their global peers.

True, economic growth in China will almost definitely weaken in the next five to 10 years, but the growth is unlikely to be slower than the global average even after that slowdown. And as the mainland banks' ROEs decline to eventually reach global levels, their average return in the next decade is likely to be noticeably higher than the global average.

Then there are the rising non-performing loans. Forget about the reported NPL ratios, and let us assume the true ratio is something like 10 per cent. In other words, the mainland banks have no capital and are insolvent.

So what? They are liquid, and public confidence is rock solid. The liquidity of the mainland banking system is unquestionable. It is worth recalling that the situation a decade ago was much worse.

The dominant religion in the investment community is to value banks against their book values. But that methodology did not help investors spot the looming subprime crisis in the United States, or the earlier Asian financial crisis, let alone the current European crisis.

Maybe we should convert to a simpler religion and treat banks as manufacturers and value them against their earnings?

Investors have reluctantly gone through that conversion on mainland real estate companies in the past decade, and on that score, the banks look good: they trade at about five times earnings and offer a dividend yield of 5 to 6 per cent a year.

Indeed, if the banks' share prices do not change much, and if their earnings grow at 10 per cent a year, their dividend yield will rise to 10 per cent in six to seven years. In other words, the share prices are likely to double to keep the dividend yield at 5 to 6 per cent.

The biggest problem with being a contrarian investor is the uncertainty on when the tide will change. Or, what will be the catalyst for the change. I do not have a crystal ball and do not pretend to know. But investors are rewarded with 5 to 6 per cent of dividends while they are waiting.

Assuming a modest growth in earnings, the banks' book values should double in about eight years. If they still trade at the current multiples (on both the PE or PB ratio), investors should double their money in that space of time. Not an exciting prospect, but better and certainly safer than most alternatives in a slowly growing global environment.

What about the two giant risks facing the mainland economy: the real estate bubble and local government debts? These are indeed major risks. But I am not alarmed. Given the low leverage ratio in the household sector, I do not foresee a sudden collapse in the sector in the next few years. To me, the countless vacancies in the real estate market are just spent household savings. These vacancies are unlikely to cause systemic risks.

But what about those local government debts? I think the right approach is to combine the debts with the balance sheet of the central government. The local governments are just branches of the central government anyway.

At present, government finances are solid. When we look at government debts, we must also consider their vast assets which can always be sold off if the need arises.

So let's become real contrarian investors and dip our hands in the mud and get a little dirty with these mainland bank stocks. One man's junk is another man's treasure, after all.

Joe Zhang is a corporate adviser and the author of Inside China's Shadow Banking: The Next Subprime Crisis?