A Niche Bank for Your Portfolio

Chinese-American banks are commercial banks that cater to Chinese people living in the United States. If you have never seen one, the best place to start is to go to the nearest Chinatown. If you are in Los Angeles, New York City, or San Francisco--three cities with large Chinese communities--it's most likely that the first bank you will encounter will be  East West Bancorp (EWBC),  Cathay General Bancorp (CATY), or  UCBH Holdings  .

The U.S. Census Bureau estimated that about 2.8 million people of Chinese descent lived in the U.S. in 2004. This population segment grows by about 8%-10% a year, so today there are probably about 3.5 million Chinese people living in America. More than 30% live in California, mainly in the greater Los Angeles area. New York City is home to the second-largest Chinese community in the country.

Serving Chinese-Americans is a lucrative business for banks. Thanks to immigration, this population segment grows twice as fast as the overall population. In addition, today's immigrants are well educated, earn decent wages, and in many cases are well off. Chinese-Americans also typically put aside more than the average American and tend to keep high cash balances for emergencies. On average, Chinese-Americans earn an above-average annual income and most likely stick to the same bank for decades. From the bank's perspective, these all translate into very loyal clients, a stable deposit base, and a low level of loan losses.

The Undisputed Rulers
When the first Chinese immigrants hit the West Coast in the early 1960s, their access to the banking system was blocked. Chinese entrepreneurs quickly recognized an opportunity, and Cathay General, East West, and UCBH were founded. Today the three banks have a 90% share of what we estimate to be a $25-$35 billion deposit market.

Small competitors spring up from time to time with attractive offers on certificate deposits, a very popular product among Chinese-Americans. These firms' success has been limited, and most of them fail to gather enough deposits to turn a profit. Mainstream banks such as  Wells Fargo (WFC) and  Citigroup (C) also try to attract Chinese Americans, so far with little success. East West, Cathay, and UCBH are brand names that are well-entrenched in the Chinese community. When new immigrants arrive in the U.S., they will most likely ask for referrals; given the 90% market share, you can guess where their business will go.

But mainstream banks also face some cultural hurdles. The gap between the cultures is so wide that mainstream banks sometimes evoke mistrust among some Chinese clients. The bustling branch of Cathay in Los Angeles' Chinatown has a completely different feel from the fancy, modern, and, unfortunately, empty neighboring Citigroup branch. Therefore, with no serious competition, East West, Cathay, and UCBH branches are keeping all the benefits of serving the Chinese-American community to themselves.

And What About Growth?
East West, Cathay, and UCBH started as savings and loans institutions. But with the growth in the number of small businesses in California and the real estate boom, commercial lending became more and more important for the trio. The shift from consumer lending to commercial lending ignited growth decades ago, and today the three banks predominantly focus on small to medium-sized business clients, while consumer loans account for less than 5% of total loans. With such compelling demographics, all three banks are terrific businesses. But the question today is this: Can this growth last, or is a slowdown inevitable? We've outlined the strategies of these three top firms, and offer our views on the current value of their shares. One disclaimer: If the flow of immigrants continues at its current pace, all three can count on stable growth in deposits, regardless of strategy. However, investors should note that if immigration slows or (even worse) reverses, the impact on profits would be substantial.

 UCBH Holdings  
Morningstar Rating: 3 Stars
Risk: Average
Economic Moat: Narrow
In its quest for growth, UCBH extended its reach well outside of California, and looked to the trade finance business. Earlier this year, the firm announced that it would acquire Business Development Bank, a Shanghai-based commercial bank. Without getting into the details of this acquisition--which we don't think was UCBH's best work--we doubt that UCBH will find much growth in this business. Trade finance products are commodities. The profit margins are thin, and the list of competitors is long--in addition, many of them are more resourceful than UCBH. Our expectations for this venture remain modest. UCBH seems to win the market over with its prospects in China, and as a result the stock trades above what we think it's really worth.

 East West Bancorp  (EWBC)
Morningstar Rating: 3 Stars
Risk: Below Average
Economic Moat: Narrow
East West has the most realistic approach to growth. The bank acknowledges its core competency--the California market--and sticks to it. East West mainly focuses on California (it has offices in other states and Asia but at a small scale), and at least for now the firm has overcome the temptation to grow outside the state. Unfortunately, the market recognizes its qualities, and the bank looks fully priced.

 Cathay General Bancorp (CATY)
Morningstar Rating: 5 Stars
Risk: Below Average
Economic Moat: Narrow
Like UCBH, Cathay's strategy to avoid a slowdown was to look for growth outside of California. However, Cathay stayed much closer to home; it bought other banks in New York and Chicago, and it hopes to evolve into a national player that caters to Chinese-Americans in several major U.S. metropolitan areas. However, we think the potential rewards from this strategy are limited, simply because most Chinese-Americans still live in California. Cathay--often overlooked by the market--is the only one trading at a discount to our fair value estimate right now, making it our top pick.