I initiated five "buy and forget" positions in Hong Kong sometime in the first quarter of 2015. Reviewing their performances to date was a moderately disappointing experience.
The Hang Seng Index, which is comprised of the 50 largest companies in Hong Kong, returned poorly (-17.35%) since January 2015. In comparison, the Standard & Poor's 500 had given a change of -0.56% over the same time frame. Interestingly, its neighbor’s (China) Shanghai Composite, which is composed of all 1,171 Shanghai A and B shares in total, also delivered a loss of 12.60% to its investors.
My portfolio, on the other hand, returned a disappointing -20.98% in the same time frame.
The previous thought-decision process that led me to buy these companies was the traditional value investing checklist. Parts of the checklist were: improving operating and profit margins, minimal to no debt, high free cash flow, low price to earnings and book value valuations and a dividend provider. I ended up being invested mostly (82%) in Hong Kong’s financial industry. Despite applying the stringent checklist in creating the portfolio, the Hong Kong portfolio did not perform well since its inception.
In addition to this overexposure, numerous reliable media sources have indicated that China has a "serious" debt problem, accompanied by the extensively discussed economic slowdown.
Nonperforming loans (NPLs)
(Visual Capitalist)
As indicated in the photo, NPLs can be quite destructive if ever increasing. In addition to this, several high profile researchers have varying takes on the exact NPL numbers.
Most banks in the U.S., as I have observed, keep huge amounts of cash, termed loan loss provisions, to cover these potential ill-fated loans. The provision would help mitigate the affectation it may yield into a bank’s earnings performance if the worst-case scenario (default) happens.
Separately, a recent Wall Street Journal article shed a light on the rising NPLs in different Chinese banks, too. Mentioned in the WSJ article were the banks Industrial and Commercial Bank of China (SHSE:601398, Financial), Bank of China (SHSE:601988, Financial), Bank of Communications (SHSE:601328, Financial) and Agricultural Bank of China (SHSE:601288, Financial).
China’s banking regulators had lowered the provision coverage requirements from 200% of bad loans to 150%. According to the article, Bank of China breached this requirement where it is currently at 149%, and Industrial and Commercial Bank of China Ltd. at 141%.
On the other hand, I can only survey the bank’s annual reports in my portfolio. Therefore, most numbers that will be discussed can be found in each of the banks’ 2015 annual reports. Being listed only in the Shanghai Exchange, Hua Xia Bank did not have an English-translated annual report. Therefore, yes, I am invested "blindly" in it. In addition, I was not able to identify Hang Seng Bank’s (HKSE:00011) provision coverage number, too.
Provision coverage for Bank of Communications has been on the decline but was able to achieve 156% in 2015. China Merchants Bank (SHSE:600036), on the other hand, had 179%. Hang Seng Bank had demonstrated an increase in its loan impairment charges as shown in the graph below.
(Bank of Communications, 2015 Annual Report)
(Hang Seng Bank, 2015 Annual Report)
China gross domestic product (GDP) growth
(Trading Economics)
By these increasing impairment charges and declining coverage ratios, one can assume that these banks are definitely engaging in riskier loans than before, which probably is a byproduct of declining GDP growth.
Debt to equity
Dividing total liabilities over total equity in the corresponding banks’ quarterly filings, I obtained the following values: 8.4% for Hang Seng Bank, 12.4% for Bank of Communications, 13.3% for China Merchants Bank and 13.7% for Hua Xia Bank (SHSE:600015). These are big liability numbers, especially for the latter three, compared to the big U.S. banks. For example, Wells Fargo (WFC) has a ratio of 8.4% while JPMorgan (JPM) has 8.7% as of recent quarterly filing.
Net interest margin
Hang Seng Bank had a 1.83% net interest margin in 2015; Bank of Communications had 2.22%; China Merchants Bank delivered 2.75%. These numbers are quite good in comparison to the big U.S. banks, which can be seen here. Further, these banks were able to deliver good enough levels of profit numbers despite its slowest profit growth in a decade.
Valuations
Traditional valuations (price to earnings and price to book value) revealed that Bank of Communications is the cheapest among the group. Overall, my portfolio certainly had declined in market value for the past year resulting in these discounted valuations.
Despite the "dire" situation that the Chinese are in, certain objective measures, such as the market-to-GDP ratio, revealed that China (Shanghai Composite) has some promising returns in the future. Market to GDP ratio is "probably the best single measure of where valuations stand at any given moment," according to Warren Buffett (Trades, Portfolio).
Market-to-GDP
(GuruFocus Global Stock Market Valuations and Expected Future Returns)
Reflecting on the series of numbers provided above, I have decided to further average down soon and on a quarterly basis so as to take advantage of Mr. Market's neglect. I am to start allocating more to the least valuable progressing to the most. This may turn out to be a not-so-smart bet, but I figure some allocation in this market would lead to a more diverse portfolio, and that the China and Hong Kong economies would eventually recover.
Happy investing!
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