Chinese brokers:Keep calm and look beyond the turbulence

Initiating coverage on Chinese brokers with a positive stance .

    We believe Chinese brokers have strong safety buffers to withstand heightened investment risks and credit risks amid the market turbulence, given their conservative risk control and strong earnings. Over the longer term, we believe the direction of China’s capital market liberalization is unlikely to be altered by recent turbulence. It should bring significant business opportunities for large brokers, potentially leading to higher long-term ROE. We initiate coverage on Chinese brokers with a positive view. Catalysts include the stabilizing A-share market and continued reforms. We prefer H-share brokers to A-share peers on valuation, with CITICS-H and GFS-H as top picks.

    Investment risks related to brokers’ Rmb128bn contribution are controllable .

    The market may have concerns regarding brokers’ investment risks, as large brokers contributed 15% of net assets (Rmb128bn in total) as part of the government emergency fund and to directly invest in A-share blue chip ETFs. We believe the market concern is overdone, as our stress test shows that listed brokers could still achieve positive earnings growth even if the investment suffered a loss of 50%. Looking ahead, we expect the investment risks to gradually fade. As suggested by other countries, it generally took three to six years to exit the stabilization funds, with most of them recording gains.

    Credit risks buffered by sufficient collateral; A-share deleveraging almost done .

    The market may also be concerned with brokers’ credit risks related to margin and stock-pledged loans, which accounted for 29% of their total assets as of 1H15. We believe the risks are protected by sufficient collateral, which covered the loan balance by 2.5x-3.0x; market index could drop at least 30% from here before triggering massive margin calls and foreclosures. For the A-share market, we believe the deleveraging has largely run its course, as total leverage has already halved to Rmb2.1tr (4.0% of market cap) from the peak.

    Recent market turmoil unlikely to reverse China’s capital market liberalization .

    We believe China’s capital market is undergoing multiple game-changing reforms. While the recent turmoil might slow the rollout of some measures, we believe it is unlikely to alter the direction of the liberalization process, given the still-elevated system credit leverage, limited wealth impact from the recent plunge and structural issues in the market. As China’s capital market becomes increasingly developed, we see robust profit potential for brokers and rising leverage if they grow their new businesses, such as market making for FICC and OTC, ABS underwriting, margin/stock-pledged loans. Our model forecasts sector ROE to reach 13.5% in 2024E (2014: 11.5%), which merits a P/B of 1.5x.

    Positive on brokers but prefer banks/Cinda; valuation and risks .

    We estimate the current valuation of H-share brokers (1.25x 2015E P/B) implies an average daily turnover (ADT) of Rmb603bn for 2015, against Rmb1.17tr in 1H15 and Rmb939bn in 2015E, on our estimates, based on backward calculations of GGM. We use a three-stage GGM to value Chinese brokers, with an average target 2015E P/B of 1.5x. On our estimates, H-share brokers are trading at 1.25x 2015E P/B and 8.7x 2015E P/E, implying 0.8x and 1.2x STD below historic means, respectively. That said, we prefer banks and Cinda over brokers, due to their more-compelling valuations. Key risks: decline in market turnover, near-term market correction and slower reform measures.