NOAH - Noah Holdings: Undervaluation And Potential For Capital Gains

2023-07-18 05:29:37 ET

Summary

• Noah Holdings Limited presents a compelling investment opportunity due to its history of stability, consistent profitability, and steady reinvestment rate.
• The company has recently shifted its capital allocation strategy to include dividend payments, a move deemed prudent given the declining return on equity (ROE).
• Despite the fundamentals fully recovering from the Covid-19 crisis, NOAH is significantly undervalued, offering a significant margin of safety and potential for substantial capital gains and favorable returns.

Introduction

For investors interested in the undervalued Chinese equity market and open to smaller Chinese companies, Noah (NOAH) presents a compelling opportunity. Despite a slight shift in recent years, the company has a history of stability, consistent profitability, and a steady reinvestment rate. While its growth rate has moderated slightly, NOAH continues to exhibit profitability and growth potential, albeit at a slightly slower pace than before. With intrinsic growth expected to be in the high single digits and the potential for a higher earnings multiple in the near future, patient investors can anticipate mid double-digit returns going forward.

Noah Holdings Limited is a leading wealth management service provider in China. They offer comprehensive advisory services for global investment and asset allocation, primarily serving high net worth investors.

Capital Allocation

NOAH has traditionally adopted a straightforward approach to allocating capital, but there has been a slight shift in recent months. Over the past 11 years, their strategy has been to reinvest all earnings back into the businesses. This strategy has proven successful, as their ability to reinvest effectively has outperformed the potential returns from share buybacks or dividends at similar valuations.

According to the graph below, the average return on equity from 2011 to 2022 was 17.68%. Given that all earnings were reinvested, this should correspond to the company's earnings per share growth during the same period. As we will soon see, this is indeed the case.

It is worth noting that the ROE has declined in recent years. As the company expands and grows larger, it becomes increasingly challenging to reinvest at the same high rate. Therefore, it would be more prudent to expect a future ROE of around 10%, which is what they did just before Covid19, and what they are currently doing, rather than anticipating a return to the previous 17% level.

The notable change in the company's capital allocation approach is the introduction of dividend payments, which they had not committed to in the past. I believe this decision to offer dividends directly stems from the declining ROE. This move is particularly wise, especially when considering the current valuations. The dividend yield surpasses the company's ability to reinvest, making it a sensible choice.

Although the company may be capable of reinvesting at a rate of approximately 10%, the dividend and share buybacks are currently yielding 14%. Given this situation, management's decision to pay dividends at current valuations is highly prudent. It also presents a lucrative opportunity for investors to achieve returns that exceed the intrinsic growth of the company.

Valuation

The company is currently highly appealing in terms of valuation, offering a significant margin of safety. Despite fully recovering from the profitability decline caused by the Covid-19 crisis, its stock price is considerably below the historical average price-to-earnings ratio of 16.7. Although the introduction of dividends does impact the earnings multiple, a single-digit P/E is not justified.

Based on the graph below, the average annual growth rate of earnings per share has been 17.41%. This aligns with the return on equity, which is to be expected since all earnings were reinvested. Estimating future growth becomes slightly more complex due to the recent shift in capital allocation strategy, which now prioritizes a dividend with a payout ratio of around 16%. At current valuations, this dividend would contribute approximately 2.35% to annual capital gains. The remaining 84% of earnings will likely be reinvested. Assuming a steady ROE of around 10% going forward, this would add an additional 8.4% to EPS growth.

Therefore, a conservative estimate suggests that annual capital gains of 10.75% can be anticipated if the company is purchased at current valuations. Moreover, a potential increase in the earnings multiple, which I believe is probable, would further enhance this estimate.

Stock Chart

Quick disclaimer: A technical analysis in itself is not a good enough reason to buy a stock, but combined with the company's fundamentals, it can greatly narrow your price target range when investing.

The company also appears to be undervalued when considering technical analysis. The stock is currently trading significantly below its 50-month moving average, which is unusual for a company that consistently achieves annual EPS growth. A return to its 50-month moving average would bring the valuation to a market capitalization similar to the estimate derived from fundamental analysis.

The duration of the correction period is uncertain, but a breakout from the declining bullish pattern could act as a catalyst. As depicted in the image, there is a downward resistance line that has been tested multiple times, and it is nearing a potential break. It may be prudent to wait for this breakout to occur before making a purchase.

Final Thoughts

In conclusion, NOAH has a history of effective capital allocation through the reinvestment of earnings, outperforming alternatives. The recent strategic shift towards dividends demonstrates a prudent approach in response to declining return on equity. Notably, the company appears significantly undervalued based on fundamental and technical analyses. This undervaluation presents an attractive opportunity for investors. Monitoring the potential breakout from the declining bullish pattern could act as a catalyst for future growth and price appreciation. Considering these factors, investing in NOAH holds substantial potential for mid double-digit returns in the long run.

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