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Beijing and Bad Debt and Banks on 5X

I thought I might introduce my first piece for eInvestHub in 2014 by touching on two broad themes: Beijing’s bad bank debt, and the relatively good run from the US share-market with over 50 per cent out-performance (against the Shanghai Composite Index) in the past seven years.

The prevailing view of many readers is that China’s communist regime will not allow an economic crash landing. Given their record foreign exchange reserves, the government can always throw money at the problem – including at the imminent doubtful debt cycle.    

The table below compares the US S&P 500 Index with China’s Shanghai Composite Index over the seven years to December 2013. The US market closed 2013 at a record-high – and 17 per cent above its pre-GFC high (1,848 v 1,576).   Meanwhile, the Shanghai Composite Index closed 2013 at 2,116 points, or 65 per cent below, its pre-GFC high of 6,124.

Table 1: S& P500 v Shanghai Composite Index, January 2007 – December 2013

  US S&P 500 Shanghai Composite
January 2007 1,418 2,675
December 2013 1,848 2,116
Record-high 1,849 6,124
7 year low    667 1,665
7 year change +30% -21%
December 2013 from record-high nil -65%
December 2013 from 7 year low +177% +27%


This contrast is illustrated in Chart 1, below.  $1.00 invested in the S&P 500 in January 2007 was worth $1.30 by December 2013 (green line), excluding dividends. Conversely, $1.00 invested in the Shanghai Composite in January 2007, was worth $0.79 by December 2013 (blue line). Hence, the S&P 500 out-performed the Shanghai Composite Index by over 50 per cent in the past seven years.

Chart 1: S&P 500 v Shanghai Composite Index, January 2007 – December 2013

Over the past seven years, the negative 21 per cent return from the Shanghai Composite Index has disappointed in comparison to China’s nominal GDP growth, which has averaged 9.7 per cent per annum. With nine of the top ten companies in the Shanghai Composite Index being state-owned, stock market returns have significantly lagged economic growth.

China appears to be gearing up for a spike in non-performing loans, and it is impossible to know the size of the bad loans associated from the so-called shadow-banking sector. The sector earns most of its income from financing riskier borrowings or giving riskier borrowers access to credit. When the value of assets decline, or cash flow is squeezed, then we are witnessing the commencement of the hangover from the investment-driven, debt-fuelled growth. Lending money to unproductive state-owned enterprises, while stimulating the economy, is not good for shareholder returns.   

China’s four major listed banks – Agricultural Bank of China, Bank of China, China Construction Bank and ICBC – have a combined market capitalisation of US$637 billion, forecast a 5 per cent growth in earnings per share (EPS) and 18 per cent return on equity (ROE) for FY14, sell at a forecast 0.9 times book value and 5 times prospective price-earnings ratio, and a 6.2 per cent dividend yield.

For context, I thought it would be useful to compare with the fundamentals of Australia’s four major banks.  At the time of writing, ANZ, Commonwealth Bank, National Australia Bank and Westpac had a combined market capitalisation of US$352 billion, forecast a 6 per cent growth in earnings per share and 16 per cent return on equity for FY14, and sell at a forecast 2.8 times book value and 14 times prospective price-earnings.

Table 2: China’s four major listed Banks v Australia’s four major listed banks

  Market Capitalisation FY14 EPS growth FY14 ROE FY14 Price/ book F’14 PE forecast
big four
$637b 5% 18% 0.9X  5X
big four
$352b 6% 16% 2.8X 14X

The Chinese Banks are selling on an average dividend yield of 6.2 per cent, while the average dividend yield for the four major Australian banks is 5.4 per cent.

Interestingly, the major Australian banks are selling at an approximate 3:1 ratio in terms of the forecast FY14 price-book value and prospective FY14 price-earnings multiple, relative to the four major Chinese banks, despite the fact they have similar EPS growth projections and ROE expectations.

Meanwhile, the US S&P 500 is up 30 per cent (excluding dividends) over the seven-year period under review and buyers who were courageous enough to wade in at the March 2009 lows have seen a near tripling of values. The US corporate profit to GDP ratio is at record highs as the relative price of labour declines.

I should, however, deliver a gentle warning in that a longer term valuation method, Shiller’s Cyclically Adjusted PE (CAPE), which uses the annual earnings of the S&P 500 companies over the past ten years, is sitting above 25X, and is over 50 per cent higher than its historical mean. Coupled with another longer-term valuation method, Tobin’s Q ratio, which focuses on the replacement value of assets and is also at the expensive end of its range, we are aware that the US share market could be viewed as rather expensive.

Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!