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What we will not buy

Updated: May 23, 2019

April 2019 Newsletter

What we will not Buy

At Ballina Capital, our investment process begins with screens that generate research ideas from global value parameters. From this research list, we’re open minded about exploring this list for attractive investments. There is, however, one group of companies upon which we will not move forward with a deep dive.

Chinese banks are a pariah from a Ballina Capital research standpoint. They can be present in abundance within our front end screens, but might as well not be. The choice is clear. My first experience as a financial analyst on Wall Street was in credit training at Chase Manhattan Bank. Profitability, Liquidity, Asset Coverage and Financial Strength provided a framework through which I came to understand the position as a lender. Lending inherently has limited upside, paired with potentially unlimited downside. This skewed relationship leads credit analysis to cautiously focus on the downside. Lenders of all varieties should have teams of credit trained professionals to scrutinize the downside with rigor.

Our position is that even though we do not have a lens into the quantity and quality of credit trained professionals in China, we doubt their number and power. We believe this because the sheer size and growth of credit through bank channels in China is unprecedented in modern history. There is simply no sign of any brakes on the credit machine in China. Bank credit is responsible for more than 2/3 of total credit available in China.

The picture that comes to mind is from the classic “Job Factory” episode of “I Love Lucy” where Lucy and Ethel are working in a candy factory. They are supposed to be wrapping candies from the conveyor belt, but the belt is going far too fast for their skills. Overwhelmed, Lucy and Ethel hilariously resort to eating or stowing as many of the candies that go by, and successfully wrapping none of them. The credit teams at Chinese banks must even more overwhelmed than Lucy and Ethel. Not able to stuff the new loans into their shirts, instead they likely sign off on virtually all new requests, and hope for the best.

Credit, mostly bank credit, has expanded at an unprecedented growth rate in China over the last 15 years. It is against the growing denominators, that the scale of the issue of NPL’s is obfuscated. NPL’s are generated, provisions are made, loans are sold, growth continues. The cycle moves on. In most locations in modern history, such a cycle would lead to a downturn, and a reckoning for the excessive lending that took place. But if the cycle just keeps going, as it has in China, problem loans can end up as new refinanced loans on another balance sheet. China has mastered the business of recycling bad credits.

China created four Asset Management Companies (“AMC’s”) in 1999 in order to deal with problem loans from the banking sector. The AMC’s, with funding from the Central Government, purchased troubled loans from the major Chinese banks. The AMC’s worked out recovery of these loans. This worked so well that all four AMC’s still exist today, and the Chinese Government has just allowed for the creation of 50 more “Local AMC’s” for the coming years. Even before these new AMC’s, in the three years between 2016 and 2018, Chinese banks disposed of 4.4 trillion yuan ($616bn USD) worth of NPLs, equivalent to 4% of total outstanding loans at the end of 2018[1]. See below. That is a massive figure. Yet despite the purge, there remained 2 trillion yuan ($280bn USD) of reported NPL’s on the books of banks in China[2]. For point of comparison, the peak figure for NPL’s held by U.S. banks came in Q1 2010, several quarters after the recession had ended. This peak figure was $375bn. Yet, it is well known that NPL’s are massively underreported in China, even by officials[3]. While more Chinese NPL’s are being recognized and more are being sold, we have little idea how many of them there actually are.

The IMF has been studying the Chinese credit cycle, and found 43 historical cases of comparable country credit booms in which the credit-to-GDP ratio increased by more than 30 percentage points over a 5-year period[4]. Among these, only five ended without a major growth slowdown or a financial crisis in the immediate aftermath. But in all credit booms that began when the ratios were above 100 percentas in China’s case100% ended badly.

Another important finding from the IMF regarding China is there is no historical precedent for the length of their credit cycle. The median duration of credit upswings is three years in Emerging countries. The Chinese cycle is 15 years and counting. When you combine the current rapid buildup in NPL’s on the bloated Bank Balance Sheets together with an economic/credit cycle that has been exceptionally long and uninterrupted, it begs the question – “What would the NPL’s look like if the Chinese economy did have a sizable contraction?” The visual of the accumulating candies as the machine speeds up for Lucy and Ethel comes to mind.

There are many reasons to believe that the Chinese economy will be able to absorb the inevitable severe credit downturn. There is a credit account surplus, small external debt, and the Central Government has the fiscal resources to mitigate the impact of the shock. However, it would take some fancy political guesswork to surmise what the capital position of a Chinese bank would be after this credit downturn. This is not the kind of guesswork we engage in here at Ballina Capital. The banks passing our screens in the table below do not gain our attention. We do own banks in our strategies. We only consider those that have the time and resources to properly assess the credits coming down the conveyer belt.

Strategy Performance

International All-Cap Value returned -1.41% (gross basis) in April 2019 versus 2.77% for the benchmark. Year to date performance was 15.1% (gross) versus 13.32% for the benchmark.

Global Small Cap Value returned -3% (gross) in April 2019 versus 2.94% for the benchmark.[5] Year to date performance was 17.76% versus 15.65% for the benchmark.

[1] Dinny McMahon, “Slow, Steady, Cheap and Painless – Making sense of China’s Bad Loan Strategy”, Macro Polo, April 8, 2019.

[2] Samuel Shen and Shu Zhang, “China’s Bad Debt Managers risk becoming bad credits themselves”, CNBC, February 13, 2019.

[3] Dinny McMahon, “Slow, Steady, Cheap and Painless – Making sense of China’s Bad Loan Strategy”, Macro Polo, April 8, 2019.

[4] Sally Chen and Joong Shik Kang, “Credit booms – Is China Different?”, IMF Working Papers, January 2018

[5] Benchmark for Global Small Cap Value comprised of 50% weight iShares Russell 2000 Index (IWM) and 50% weight Vanguard FTSE All-World ex-US Small-Cap ETF (VSS)

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