Banks - a stock market perspective

Tuesday, 10th April 2018 07:53 - by David Harbage

The banking industry has taken a lot of criticism from politicians, regulators, the media and customers alike over the past decade - especially in the United States of America and the United Kingdom. So-called 'banker bashing' has become a national sport since 'bankers' were accused of misbehaviour (primarily in unsound mortgage lending in the US and the construction of complex, flawed financial products in many Western developed countries) which in turn contributed to an economic depression.

From an investors' perspective, many have shied away from an industry that they perceive as being a 'soft target' for regulators (imposing fines for poor behaviour - think of traders rigging interest rates), litigation in general (consumers erroneously or inappropriately sold PPI), politicians (levying exceptional corporate taxes), increasingly complex balance sheets (recognised post the banking crisis of 2008) and less than transparent reporting (level of exceptional items - both positive and negative - contributing to an opaque business model) which led to a lack of understanding of these businesses’ core, underlying earnings. Supposedly smart fund managers (such as Neil Woodford) - to say nothing of qualified accountants - decided that the risks of getting to know these businesses better were outweighed by the prospect of further 'bumps in the road ahead'.

Last week's article entitled 'A new tax year prompts decision making' could have been expanded to include the words 'fresh thinking'. The author has been wary about the prognosis for banks for many years (with the exception, occasionally, of HSBC - as a proxy for global economic activity), but may be warming to the sector, prompting the reader to question what has changed?

On fundamental considerations, a belief that banks are beneficiaries of higher interest rates - a cycle or trend which has begun in the UK, albeit not at the same pace as elsewhere (notably, in the United States). Historically in such a rising rate scenario, banks can earn more on dormant bank accounts (individuals have typically become laissez faire in managing their cash, leaving ever higher non-interest earning balances on their current accounts), as well as expand their traditional profit margins (interest allowed on deposits, versus that charged on loans).

Secondly, valuation has become more favourable: after a sustained period (a number of years) of underperformance relative to the wider UK equity market, bank shares are beginning to look more attractive - both on comparing their equity (or share) price to their book price and also on examining their likely profits in the current calendar year. Lloyds have become profitable to the extent of paying dividends and no longer have the yoke of HM Government ownership to consider. Royal Bank of Scotland are a bit further 'behind the curve' in their restoration, but the group is now profitable and its more precarious state of financial health makes it likely to represent higher risk-reward, at the margin (according to whether it succeeds or struggles) bank, than its peers.

Based on share price versus book value (net tangible asset worth), Barclays looks attractive - boasting one of the widest gaps, via a 37% discount, to asset value amongst the FTSE100 index's constituent businesses (twice that of Lloyds’). On fundamentals, the US Department of Justice recently handed out a US$2bn fine to Barclays - a huge sum, but less than expected by analysts (equating to less than one half of one percent of the bank's Tier 1 capital ratio) and perhaps one of the last big litigation issues overhanging the stock. By reference to other claims, an end is in sight for the domestic PPI 'money tree' and, looking forward (as markets quite rightly do), the comparative earnings picture is becoming much brighter.

Sentiment is certain turning more positive over the past six months: the broking community is currently publishing 10 Buy recommendations, 7 Holds and just 2 Sells (there were six sellers in October 2017). Incidentally, the recent 'successful' US court claim decision is likely to boost Barclays' returns to shareholders - via a higher dividend or a buyback of shares, which are perceived by management as being undervalued.

An improvement in cash retention could also prompt the senior management of the banks to reconsider corporate activity, managers like Barclays' CEO Jes Staley have much to prove to shareholders after recent troubled times. Activist fund managers - like Edward Branson, who took a 5.2% stake last month - are likely to be less patient (than traditional investors, such as UK recovery-oriented fund managers, who have for a long time dominated the share register) and will put more pressure on the board to effect clear 'value adding' corporate strategy - now that MIFID regulation-driven separation of business divisions has been effected.

Another prime reason for reconsidering banks as an interesting equity investment opportunity is their current PEG rankings, as compared to the overall UK equity market; the PEG assesses a company's price-to-earnings multiple (or PE ratio) with the pace of its earnings growth. Where a company stock is priced at a lower than average PE rating, but evidences above average profit growth (emanating from its core, underlying business - rather than from exceptional source, or as a result of easy historic comparatives) then it becomes appealing. A number of banks are demonstrating such growth at reasonable price (GARP) status, as current calendar year trading is strong. As poor prior claim experience comparatives drop out, Barclays earnings per share (EPS) is set to grow 460% to 19.7p in 2018 - but also by a further 19% to 23.4p in 2019 which puts stock on a forward-looking PE of 9x. Insofar as income is concerned, one third of profit is being distributed as a dividend (this proportion is set to rise in 2020), so the shares are likely to yield 3.8% based on today’s price.

By contrast, the more domestic and consumer-focused (or dependent, according to the reader’s perspective) Lloyds business - please remember that this is the owner of what was the Halifax Building Society and the Bank of Scotland - is paying out a higher proportion of the profits it generates. In the current trading year, Lloyds is expected to deliver a 67% jump in EPs to 7.3p (again, per Barclays, aided by favourable comparatives) but by just 1% in calendar year 2019. Consensual opinion has it that a dividend of 3.8p will be paid on 2019’s profits, equating to an income yield of 5.7% at the current share price. Although regular readers will know that the writer is bullish on new house builders (primarily on valuation, to be specific), he is not enthused by the immediate outlook for house price inflation or the secondary residential market at large. Analysts tend to agree that Lloyds offers less growth potential (13 Buy recommendations, 3 Holds and 5 Sells) and the indicative PE of 9x for 2019 is as likely to rise as fall looking further out.

Looking further afield, the more international concern HSBC offers growth (representing a reasonable play on global GDP or economic activity) on a PE of 12x for the year to 31 December 2019 - but this stock’s higher valuation is underpinned by a near 1.5 times covered dividend, pointing towards an income yield of 5.7%. To complete the comparison of broker views on these banks, there are currently 5 Buy opinions on HSBC, while 13 are neutral and 3 publish Sells.

Royal Bank of Scotland will be profitable this year but earnings growth is unimpressive - via 0% this year and 10% in 2019) - putting the stock on a PE of 9.2 times next year’s EPS. Paying out 45% of 2019’s profits, the prospective dividend yield is 4.9%. Broker research is generally positive (8 Buys, 11 Holds and 1 Sell), but many caution on the quality or reliability of the group’s earnings in  the short term.

Bottom line, the sector remains higher risk-reward as compared to many other industries, but news flow appears to be improving and investor sentiment too.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.