Purchasing H-shares of China CITIC Bank (0998.HK) for my Dividend Income Portfolio

Summary

In this article, I examine the valuation of the H-share of China CITIC Bank (0998.HK) from the view point of a Dividend Investor. The Dividend Discount Model (DDM) is used to determine its Intrinsic Value, Expected Return on Investment, and its Margin of Safety. DDM is a form of Discounted Cash Flow Analysis in which the type of cash flow used in the analysis is the Company’s regular dividend payments, discounted at the appropriate rate of return to determine the Intrinsic Value of the stock.

Introduction

The recent Evergrande debt crisis has resulted in a substantial sell down in the Hong Kong equities market, with the bulk of the price decline hitting China H-shares. A few companies on my watch list experienced price corrections which brought them into value stock territory, at least that is my humble opinion. I have recently published articles on 2 of them, namely Ping-An Insurance, Agricultural Bank of China. In this article, I would like to share my thoughts on another recent addition to my Dividend Income Portfolio, China Citic Bank (0998.HK).

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 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 company to find the answers.

Background Information on the China CITIC Bank

China CITIC Bank was founded in April 1987 and is part of CITIC Group Corporation, a state-owned investment company of the People's Republic of China. The Bank was successfully dual-listed on the Stock Exchange of Hong Kong and the Shanghai Stock Exchange on 27 April 2007.

CITIC Group is considered to be a State-owned Bank as the majority of ordinary shares are held by State-owned Entities, the largest being CITIC Group Corporation which holds 65.37% of the ordinary shares as of December 2020.

China CITIC Bank's long term dividend track record

The Bank has a history of dividend payments since its dual listing on the Hong Kong Stock Exchange and the Shanghai Stock Exchange on 27 April 2007.

Data Source: Company Annual Reports

It is noted that the Bank did not pay out dividends to ordinary shareholders in Fiscal Year 2010 and 2014. The Bank was planning for a Rights issue in 2011 and Management decided that withholding the dividend payment for 2010 would be less disruptive to the Rights issue exercise. As stated in the FY2010 Annual Report, the reason for not issuing dividends for the year is "to ensure the smooth proceeding of the Rights Issue, the Bank decides not to arrange cash dividend distribution for 2010". Similarly, the Bank was planning a private placement of A-shares to China Tobacco in 2015, nad Management also decided withhold dividend payment to minimize disruption to the private placement exercise which was successfully completed in December 2015. And in FY2014 Annual Report, the following justification was provided: "In consideration of its proposed non-public offering of A Shares to China Tobacco Corporation, pursuant to relevant regulatory requirements, and in order not to affect the progress of the non-public offering and promote its own long-term development, the Bank will not make any dividend distribution in cash for FY2014."

Other than the 2 years in which the Bank elected not to pay dividends for reasons explained earlier, China CITIC Bank has increased its dividends to ordinary shareholders from 0.0535RMB in FY2007 to 0.254RMB in FY2020, resulting in a Compounded Annual Growth Rate of 12.73%.

To its credit, Company Management demonstrated its commitment to rewarding shareholders by continuing 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.

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

For FY2020, China CITIC Bank declared dividends of 0.254RMB per ordinary share, which is equivalent to 0.3048HK$. On 24th September 2021, the H-share of the Bank closed at 3.35HK$ per share. This translates into a dividend yield of 9.099% which is considerably higher than the average dividend yield of the constituent stocks of Hang Seng Index.

Data Source: AAStocks.com

Is the current payout ratio of China CITIC Bank (0998.HK) sustainable?

In the last 6 years (FY2015 to FY2020) the dividend payout ratios of the major China Banks, 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. Ownership structure of these large banks, and the importance of their dividends to central government revenues.
2. Regulatory reasons which may discourage the banks from making large cuts to the payout ratios, with special significance around the 30% level.
3. The large China banks' 30% dividend payout ratio levels are by no means aggressive, and are well below the global bank median.
4. Capital ratios look more than adequate for the large banks relative to minimum regulatory requirements.
5. Dividend payout ratio cuts do not save much Tier 1 capital, so there is little point in slashing the dividend payout to save capital.
6. 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 China CITIC Bank. An important point to note is that the Bank's FY2020 dividend payout ratio of 27% is lower than the average payout ratio of the four big state-owned commercial banks, and the corresponding Dividend Coverage Ratio of 3.70 which is generally considered to be a comfortable cover.

What is the expected return on investment for China CITIC Bank (0998.HK) 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. Period = 10 years
2. Terminal growth rate = 2.5%
3. Risk Free Rate = 1.191% (10 year Hong Kong Government Bond Yield on 24th September 2021)
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. China CITIC Bank Beta = 1.05. This is the average beta from data provided by Reuters, Marketwatch.com and Investing.com which works out to be 0.95. An additional 10% margin is added to arrive at a beta of 1.05. The beta for the major China commercial banks has 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

1. Currency Exchange Rate = 1.20 HK$/RMB
2. Discount Rate = Risk Free Rate + Beta x Market Risk Premium = 1.191% + 1.05(10.5%) = 12.216%
3. The Earnings per share growth rate is modeled to decline gradually from 4% in FY2021 to 2.65% in FY2030. The resulting CAGR in EPS from FY2020 to FY2030 is 3.32%. Note that this is a conservative assumption, considering that the CAGR of EPS from FY2007 to FY2020 is equal to 11.51%.
4. The Dividends are modeled to grow at CAGR of 2.92% from FY2020 to FY2030, assuming a constant payout ratio of 26.0%. This is a conservative assumption, considering that the CAGR of Dividends from FY2007 to FY2020 = 12.73%.
5. The Book Value per share is modeled to grow at CAGR of 6.558% from FY2020 to FY2030. Again, this is a conservative assumption, considering that the CAGR of Shareholders' Equity from FY2007 to FY2020 = 12.04%.

China CITIC Bank 10 year Dividend Discount Model

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

1. Total of Discounted Dividends (FY21 to FY30) = 1.6149RMB
2. Expected Price to Book Value Ratio in FY30 = (ROE-g)/(K-g) = (7.4423%-2.5%)/(12.216%-2.5%) = 0.5087
3. Expected Book Value of the Bank in FY30 = 17.9872RMB
4. Expected Stock Price in FY30 = 0.5087 x 17.9872 = 9.1501RMB
5. Present Value of FY30 Stock Price = 9.1501/(1.12216)^10 = 2.8899RMB
6. Estimated Intrinsic Value of the H-share = 1.6149 + 2.8899 = 4.5048RMB which is equal to 5.4058HK$ per share.

Based on the Dividend Discount Model, the intrinsic value of the H-share of China CITIC Bank is estimated to be approximately 5.4058HK$ per share when discounted at the rate of 12.216% per annum.

One way to interpret the results above is that an investment into the Bank's H-share at a price of 5.4058HK$ is expected to provide a return on investment of 12.216% per annum over a 10-year period.

The goal seek function of Excel can be used to find a discount rate which will yield an intrinsic value equal to the purchase price of 3.35HK$. This discount rate is found to be equal to 16.29%. In other words, an investment into the H-share of the China CITIC Bank at a price of 3.35HK$ is expected to provide a return on investment of 16.29% per annum over a 10-year period.

Does the current valuation of China CITIC Bank (0998.HK) offer a sufficient margin of safety?

On 24th September 2021, the Bank's H-share closed at 3.35HK$ per share. With an estimated intrinsic value of 5.4058HK$, this translates into a margin of safety of 38.03%.

Are the H-shares of China CITIC Bank (0998.HK) 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 3.35HK$ per share, the following observations are made:

• Trailing PE Ratio:EPS FY2020 = 0.939RMB = 1.127HK$PE = 3.35/1.127 = 2.972The price represents an opportunity to own a stake in a major commercial bank in China, at an attractive discount with a payback period of less than 3 years.
• PBV Ratio:Book Value FY2020 = 9.53RMB = 11.436HK$ per sharePBV = 3.35.58/11.436 = 0.293The Return on Equity of the Bank in FY2020 is 10.20%. Using a discount rate of 12.216% and a growth rate of 2.5%, the expected PBV can be estimated to be 0.792. Applying a 30% discount to this estimated value implies a fair PBV of 0.554. This represents an upside of 89.1% from the current PBV of 0.293.

Does China CITIC Bank have a history of consistent earnings growth?

The table below shows the history of earnings per share of the Bank from Fiscal Year 2007 to Fiscal Year 2020. As can be seen from the data, China CITIC Bank has a consistent track record of positive earnings since its public listing. It is worth noting that from 2007 to 2020, the earnings per share of the Bank grew at a compounded annual growth rate (CAGR) of 11.50%.

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 China CITIC Bank (0998.HK) 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. China CITIC Bank has managed to grow its dividends to ordinary shareholders from 0.0535RMB in FY2007 to 0.254RMB in FY2020, resulting in a Compounded Annual Growth Rate of 12.73%.
2. The H-share currently offers an attractive dividend yield, which is higher than the average yield of Hang Seng Index constituent stocks.
3. The Bank's current payout ratio of 27% is lower than the average payout ratio of the four largest State-owned Commercial Banks in China, and the corresponding Dividend Coverage Ratio of 3.70 is generally considered to be good.
4. An investment into the H-share of the Bank at a price of 3.35HK$ is expected to provide a return on investment of 16.29% per annum over a 10-year period .
5. The intrinsic value of the H-share is estimated to be 5.4058HK$ per share, representing a 38.03% margin of safety over the price of 3.35HK$.
6. The H-shares of the Bank are currently trading at inexpensive valuations when measured against traditional value investment yardsticks.
7. China CITIC Bank has a consistent track record of earnings per share growth since the listing of its H-share in 2007. From FY2007 to FY2020, its earnings per share has increased at a compounded annual growth rate of 11.50%.

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.