Purchasing H-shares of Agricultural Bank of China (1288.HK) for my Dividend Income Portfolio

Summary

In this article, I examine the valuation of the H-share of Agricultural Bank of China (ABC 1288.HK) through the eyes of a Dividend Investor. Dividend Cash Flow analysis was used to assess the H-share of Agricultural Bank of China. The Dividend Discount Model was employed to determine its Intrinsic Value, Expected Return on Investment, and its Margin of Safety.
Continue reading to learn more.

Introduction

Following on from my previous article on the H-shares of the China Construction Bank (CCB), I recently purchased the H-shares of the Agricultural Bank of China (ABC). In this article, I would like to discuss the reasons why I decided to add the shares to my Dividend Income Portfolio.

As my investment philosophy evolves over time, I find myself favoring stocks which provide attractive dividends at inexpensive valuations. I used the following set of questions to help determine the Bank's investment worthiness:

• • Does the Bank have a good long-term dividend track record?

• • Does the Bank currently offer an attractive dividend yield (above the average yield of Hang Seng Index constituents)?

• • Is the current payout ratio safe and sustainable?

• • What is the expected return on investment of the share over a 10-year period? Majority of recommendations by financial analysts tend to have a 12 month time horizon. I find the 10-year period to be more suitable for a dividend income stock, especially one which is part of a retirement dividend income portfolio.

• • Does the stock price offer a sufficient margin of safety to its intrinsic value?

• • Are the shares considered attractive when measured against the traditional value investing yardsticks? A good dividend stock with inexpensive valuation will minimize the risk of capital impairment and increase the probability of capital gains.

• • Does the stock have a history of consistent earnings growth?

With the above questions in mind, let us delve into the analysis of the stock to find the answers.

Background Information on the Agricultural Bank of China (ABC)

Agricultural Bank of China traces its history back to 1951, the year that the Agricultural Cooperative Bank was founded as a wholly state-owned bank. It is currently the third largest commercial bank in China and also in the world in terms of assets.

Agricultural Bank of China is considered to be a state-owned commercial bank. Two of its largest shareholders are the state-owned Huijin and the Ministry of Finance. Both entities own 40.03% and 35.29% of ordinary shares respectively.

Does Agricultural Bank of China (ABC) have a good long term dividend track record?

The Bank has an uninterrupted track record of dividend payments since its dual listing on the Hong Kong Stock Exchange and the Shanghai Stock Exchange in July 2010.

Data Source: Company Annual Reports

In addition to its impressive history of dividend payments to shareholders, the Bank's dividend per share has also increased steadily from 0.054RMB per share in FY2010 to 0.1851RMB per share in FY2020, growing at a compounded annual growth rate of 13.11%.

Further evidence of the Management’s commitment to rewarding its shareholders, the company continued to pay a full dividend in the year 2020, a year in which the world economy was severely affected by the Covid-19 health crisis. In the same year many banks around the world, including European banks and American banks were forced to severely reduce or eliminate their dividend payments. This is testimony to Agricultural Bank of China’s excellent dividend track record since its public listing in 2010.

Does Agricultural Bank of China (ABC) currently offer an attractive dividend yield (above the average yield of Hang Seng Index constituents)?

For FY2020, Agricultural Bank of China declared dividends of 0.1851RMB per ordinary share, which is equivalent to 0.222HK$. On 20th September 2021, the H-share of the Bank closed at 2.58HK$ per share. This translates into a dividend yield of 8.60% which is substantially higher than the average dividend yield of the constituent stocks of Hang Seng Index.

Data Source: AAStocks.com

Is the current payout ratio of Agricultural Bank of China (ABC) sustainable?

In the last 6 years (FY2015 to FY2020) the dividend payout ratios of the major China Banks, including that of the Agricultural Bank of China, have stabilized at around the 30% to 30.5% level.

Data Source: CGS-CIMB Report on China Banks dated 28 July 2021

CGS-CIMB, in their report on China Banks titled “In Dividends We Trust” dated 8th April 2020, put forward 6 reasons why the dividend payout ratios of the large Chinese State-Owned commercial banks are considered to be sustainable at current levels (Quoted verbatim from page 7 of the said report):

1. 1. Ownership structure of these large banks, and the importance of their dividends to central government revenues.

1. 1. Regulatory reasons which may discourage the banks from making large cuts to the payout ratios, with special significance around the 30% level.

1. 1. The large China banks' 30% dividend payout ratio levels are by no means aggressive, and are well below the global bank median.

1. 1. Capital ratios look more than adequate for the large banks relative to minimum regulatory requirements.

1. 1. Dividend payout ratio cuts do not save much Tier 1 capital, so there is little point in slashing the dividend payout to save capital.

1. 1. Slower loan growth as well as continued shift in loan book mix towards retail and away from corporate going forward means less pressure on capital, even after factoring in the falling pace of organically generated capital. Falling provisioning coverage ratios for some of the mid-large banks could also boost core Tier 1 ratios.

The above 6 reasons given by CGS-CIMB make a strong case for the sustainability of the dividend payout ratio of Agricultural Bank of China.

What is the expected return on investment for Agricultural Bank of China (ABC) over a 10-year period?

A cash flow analysis was carried out to determine a reasonable estimate of the expected return on investment for the H-share of the Bank over a period of 10 years. The Dividend Discount Model was adopted. Key parameters for the cash flow model are as follows:

1. 1. Period = 10 years

1. 1. Terminal growth rate = 2.5%

1. 1. Risk Free Rate = 1.077% (10 year Hong Kong Government Bond Yield on 20th September 2021)

Data Source: market-risk-premia.com

4. 4. HK Stock Market Risk Premium = 10.50% (Approximately equal to the Market Risk Premium at the depths of 2008 Global Financial Crisis according to Market Risk Premia)

Data Source: market-risk-premia.com

5. 5. Agricultural Bank of China Beta = 1.00. This is a conservative estimate. The average beta from data provided by Reuters, Marketwatch.com and Infrontanalytics.com works out to be 0.76. Furthermore the beta for the major China commercial banks have been consistently dropping as can be shown in the graph below, provided by CGS-CIMB in their report dated 28th July 2021.)

Data Source: CGS-CIMB Report on China Banks dated 28 July 2021

7. 7. Currency Exchange Rate = 1.20 HK$/RMB

7. 7. Discount Rate = Risk Free Rate + Beta x Market Risk Premium = 1.077% + 1.0(10.5%) = 11.577%

7. 7. The Earnings per share growth rate is modeled to decline gradually to 2.55% in FY2030. The resulting CAGR in EPS from FY2020 to FY2030 is 2.78%. This is a drastic decline from the CAGR of 5.98% achieved from FY2010 to FY2020.

7. 7. The Dividends are modeled to grow at CAGR of 2.485% from FY2020 to FY2030, assuming a constant payout ratio of 30.5%. This is a conservative assumption, considering that the CAGR of Dividends from FY2010 to FY2020 = 13.11%.

7. 7. The Book Value per share is modeled to grow at CAGR of 6.576% from FY2020 to FY2030. Again, this is a conservative assumption, considering that the CAGR of Shareholders' Equity from FY2010 to FY2020 = 12.43%.

From the above cash flow model, the following values are calculated:

1. 1. Total of Discounted Dividends (FY21 to FY30) = 1.182RMB

1. 1. Expected Price to Book Value Ratio in FY30 = (ROE-g)/(K-g) = (7.82%-2.5%)/(11.577%-2.5%) = 0.587

1. 1. Expected Book Value of the Bank in FY30 = 10.19RMB

1. 1. Expected Stock Price in FY30 = 0.587 x 10.19 = 5.98RMB

1. 1. Present Value of FY30 Stock Price = 5.98/(1.11577)^10 = 2.00RMB

1. 1. Estimated Intrinsic Value of the H-share = 1.1824 + 2.00 = 3.1824RMB which is equal to 3.819HK$ per share.

Based on the Dividend Discount Model, the intrinsic value of the H-share of Agricultural Bank of China is estimated to be approximately 3.819HK$ per share when discounted at the rate of 11.577% per annum.

One way to interpret the results above is that an investment into the Bank's H-share at a price of 3.819HK$ is expected to provide a return on investment of 11.577% per annum over a 10-year period.

The goal seek function of Excel can be used to find a discount rate that will yield an intrinsic value equal to the purchase price of 2.58HK$. This discount rate is found to be equal to 13.69%. In other words, an investment into the H-share of the Agricultural Bank of China at a price of 2.58HK$ is expected to provide a return on investment of 13.69% per annum over a 10-year period.

Does the current valuation of Agricultural Bank of China (ABC) offer a sufficient margin of safety?

On 20th September 2021, the Bank's H-share closed at 2.58HK$ per share. With an estimated intrinsic value of 3.819HK$, this translates into a margin of safety of 32.44%.

Are the H-shares of Agricultural Bank of China (ABC) considered inexpensive when measured according to traditional value investing yardsticks?

Some popular yardsticks to gauge the value of stocks as investments include the Price to Earnings ratio and the Price to Book Value ratio. In this section, we will see how the Bank's H-shares measure up against these benchmarks. Based on the stock price of 2.58HK$ per share, the following observations are made:

• • Trailing PE Ratio:
    • • EPS FY2020 = 0.59RMB = 0.71HK$
    • • PE = 2.58/0.71 = 3.644
    • • The price represents an opportunity to own a stake in one of the largest commercial banks in the world, in terms of assets, at an attractive discount with a payback period of less than 4 years.

• • PBV Ratio:
    • • Book Value FY2020 = 5.39RMB = 6.47HK$ per share
    • • PBV = 2.58/6.47 = 0.399
    • • The Return on Equity of the Bank in FY2020 is 11.40%. Using a discount rate of 11.577% and a growth rate of 2.5%, the expected PBV can be estimated to be 0.98. Applying a 30% discount to this estimated value implies a fair PBV of 0.686. This represents an upside of 71.9% from the current PBV of 0.399.

Does the stock have a history of consistent earnings growth?

The table below shows the history of earnings per share of the Bank from Fiscal Year 2010 to Fiscal Year 2020. As can be seen from the data, Agricultural Bank of China has a consistent track record of positive earnings since its public listing. It is worth noting that from 2010 to 2020, the earnings per share of the Bank grew at a compounded annual growth rate (CAGR) of 5.98%.

Data Source: Company Annual Reports

Conclusion

In this article, I set out to document the rationale behind my recent investment decision to purchase the H-shares of the Agricultural Bank of China (ABC) for my dividend income portfolio. The many reasons I found the H-share of the Bank to be an attractive investment can be summarized as follows:

1. 1. Agricultural Bank of China (ABC) has a good long-term dividend track record.

1. 1. The H-share currently offers an attractive dividend yield which is higher than the average yield of Hang Seng Index constituent stocks.

1. 1. The current payout ratio of the Bank is sustainable.

1. 1. An investment into the H-share of the Bank at a price of 2.58HK$ is expected to provide a return on investment of 13.69% per annum over a 10-year period .

1. 1. The intrinsic value of the H-share is estimated to be 3.819HK$ per share, representing a 32.44% margin of safety over the price of 2.58HK$.

1. 1. The H-shares of the Bank are currently trading at inexpensive valuations when measured against traditional value investment yardsticks.

1. 1. Agricultural Bank of China has a consistent track record of earnings per share growth since the listing of its H-share in 2010. From FY2010 to FY2020, its earnings per share has increased at a compounded annual growth rate of 5.98%.

Disclaimer:

This article is a record of the thinking behind a personal investment decision. It does not represent any recommendation to purchase any stock mentioned in the article. As always, readers are strongly advised to do their own due diligence before making any investment decisions.