Trade view /
25 July 2017 at 14:30 GMT
As we have alluded to in our commentary during morning calls and also in our regular webinars, US banks are generally scoring negative in our quant model due to above average valuations and low yields. The latter are a function of Fed's tough stress tests putting constraints on the yield.
On the other side of the spectrum we find banks in China, Australia and Canada. Given the latest positive momentum in China and Chinese banks' underperformance vs global peers we are focusing on ICBC (Industrial and Commercial Bank of China) as an attractive trading idea over the next six months as we expect momentum to keep up for the rest of 2017. ICBC is ranked as the 9th most attractive global bank in our quant model.
ICBC has experienced rapid growth over the past ten years with book value per share growing 14.3% annualised tracking the estimated growth rate of US banks during the growth decade of the 1920s as we wrote about recently in our analysis of the Chinese property market
But as the chart below shows growth in book value per share has slowed to the lowest levels since Q1 2010 at around 5% y/y, still surpassing many banks in the developed world. However, based on our macro outlook and especially the signals coming out of China and western companies operating in the country, things are improving and as a result we are expecting growth in loans and book value to pick up again. One of the key growth drivers in China will continue to be urbanisation as China's urbanisation rate is still only at 56% compared to 80-85% in many developed countries.
One of the most important ratios for banks and their valuation is the spread between return on equity and the cost of equity ("economic profit spread"). Historically this ratio has been robust at ICBC and it has lately turned higher indicating that costs are under control and things are improving. With a price-to-book ratio at 0.85 the stock remains attractive on valuation. European banks with similar economic profit spread (typically seen among Nordic banks) are trading at price-to-book ratios closer to 1.5-2, so there is plenty of upside for ICBC. China's capital controls and EM country status obviously feeds into a valuation discount but it seems global investors are overly worried about Chinese banks.
ICBC has a high core Tier 1 capital ratio of around 13% compared to global peers and the net interest margin continues to be attractive although it has fallen in recent years. In addition ICBC has moved aggressively on loan provisions against non-performing loans so that the loan loss reserve to non-performing asset ratio is now 142% indicating that the bank is expecting more bad loans but provisions have already been set aside. On the flip side it creates a potential gain on the income statement should credit quality in non-performing assets improve.
Adding to ICBC's positive outlook Caterpillar published stronger than expected Q2 earnings today. Caterpillar's earnings outlook is normally a good indicator on global growth as construction through building permits feed into leading indicators on the economy. In addition Caterpillar has a global footprint with big exposure to Asia. Management highlighted especially growth in China that is rebounding from 2015 lows. Leading indicators on China (see chart below) are also indicating positive momentum in China.
China Leading Index (1996 = 100)
July has been a volatile month for the share price, but the recent bounce back on better macro data is bolstering our outlook and sentiment on the Chinese banking industry. The stock price is at breakout levels and if data continue to be positive against expectations we expect the Chinese banking industry to get repriced at better valuation multiples.
ICBC weekly share price since 2012
Source: Saxo Bank
Based on the economic profit spread and improved outlook the share price should at least be 7 and estimate fair value to be closer to 7.5
The research for this trade idea was provided in collaboration with my great colleagues out of Asia, Hong Wei Lee and Shiyun Su.
Management and risk description
The obvious risk to our trade is deteriorating macro fundamentals out of China or a slowdown in the US as it is one of China's largest export markets. Further weakness in the USD could derail out positive outlook as the Chinese economy is still export-driven although the economy is transitioning towards being a consumption-driven economy. Worse than expected Q2 earnings and outlook on August 30 is obviously also a key risk factor for investors being long the shares.
Limit buy in the range 5.30-5.50
Stop loss is set at 4.80 which is just below recent support levels in July. The stop price corresponds to expected maximum loss of 11% Please remember that stop loss is not guarantee as they can be "jumped over" in opening auctions due to events announced outside trading hours.
We are setting an aggressive target price of 7.25 which we estimate to be fair value should the re-valuation of Chinese banks continue of the backdrop of better macro data.
Our time horizon is medium term indicating around 6-9 months which fits with the projection we are getting from the leading indicators
— Edited by Clemens Bomsdorf
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