Buy the Banks?

As seen in this month’s issue of Master Investor Magazine.

Life here goes on in its usual magical way; a bit like Prospero’s magical Isle – as Mr. W. Shakespeare of Stratford on Avon would have put it. Things happen and you do not quite know how or sometimes why; a bit like the internet or even life itself.

However, there are notes in bottles from the Editor from time to time. There are also arrivals to the Limpopo Shangri la from the outside world, to keep one in touch with the great conflicted universal reality beyond these happy harmonious shores.

Immigrant bankers usually arrive at dead of night, and always leave very early. They have been coming and going in rhythm with the ebb and flow of regulatory enquiries and solicitors’ letters from former bank customers who feel that banks have been less than helpful to them at various times. A classic example being those SME companies who felt that they had been put out of business by their banks allegedly in exchange for thirty pieces of silver of banking fees and subsequent profit margins. In the case of state owned RBS, the Bank of England reportedly said that they found no evidence of wrongdoing but added that the bank’s customers had been “let down.” A bit like the tyre of a Formula I racing car in a winning lap.

It is astonishing how such complaints continue to burst through the lawn of the bankers’ garden like knot weed. The dilemma is to know how to eradicate the pernicious growth of weedy, unacceptable conduct. Bring back the Quakers is my own suggestion.

These thoughts of banks and bankers have prompted me to ease up on the jungle juice and have a look at UK banking shares from the perspective of the equity investor. I have come to the conclusion that they are still good value. Putting down my cocoa nut shell of a splendid Limpopo cocktail containing its brightly coloured mini sunshade umbrella, I now offer reasons why.

Why banks are attractive

Most banks, despite their chronic public relations problems have put in a solid performance in terms of share price.

However, they still look appealing for the following reasons:

• Above average dividend yields.
• Banks sell near to or sometimes above balance sheet book value.
• They are a geared/leveraged play on economic growth.
• Bank ratings are still influenced by past fears.

The capital versus dividends debate

Most banks still have a decent annual dividend yield and dividend growth prospects, despite the competing need to find capital for balance sheet regulatory purposes. The boards of banks wish to reward investors (including themselves through share incentive schemes) with dividend increases. Against that, governments, banking regulators and academics constantly worry about another banking crisis and want banks to put more capital onto their balance sheets to reduce their gearing and risk.

There are innumerable ideas as to what that should be in terms of balance sheet percentage; some critics for example, going as high as 16%. The idea that banks should be left, even under the current Basel  Treaty regulations, to identify and measure levels of risk in relation to the different types of lending and then weight the balance sheet with the exactly appropriate level of capital to reasonably absorb that risk does not win everybody over, for a number of fairly obvious reasons. There is a more simplistic, plain gearing pressure group which believes that the risk weighted malarkey is too theoretical and subjective a process to be sufficiently reliable. Their view tends to favour the strength and reliability of simplicity; for each and every pound of lending and obligation a given level of capital with no mucking about.

Capital requirement, remains a tug of war of professional opinion between regulatory puritans, pulling for the biggest amount of capital to anchor bank balance sheets, and the economic policy pragmatists (and bankers of course), who pull for the smallest amount. So banks, as equity investments, are in a constant state of mixed apprehension as the two sides continue to pull against each other. It is a tug of war in which there will be no outright winners. It is always in a state of flux and moving compromise.

There is also the matter of the Chancellor’s special tax on bank profits as a means of reducing the national deficit. Banks complain about that on top of normal regulatory costs, but it will not be unpopular with the voting public, who reckon it to be fair and just desserts. Banks argue that special bank taxation is too onerous on top of the costs of meeting the demand that they separate ‘traditional’ clearing bank deposit and lending activities from ‘casino’ investment banking.

As investors should we expect more financial security with more capital requirements but less profit and dividend growth; or should we expect earnings and dividend growth because we have reached the high water mark of regulatory capital requirements and special bank taxes? That is the question, to which the answer is a matter of individual judgement.

It is not an easy matter to judge. Universal experience shows compromise and short term expedience, a powerful influence in the world’s affairs. Politicians and government policy makers have short term spans of interest and will likely give weight to a growing GDP, helped by maximum bank lending. The possibly longer term threat of another banking collapse looks a bit more of a luxury option compared with short term GDP attraction. The extreme puritan highest capital solution will not be adopted. The target will always be a compromise figure hovering between extremes.

Banks still wield an enormous amount of influence through lobbying and political influence and connections. To prove the point, investment banks have not been statutorily and corporately separated from the common ownership of their deposit and lending arms, as they were in the US after the great crash of 1929. They have had to agree to separating ‘casino’ investment banking from deposit and lending banking into separate subsidiary operations and make arrangements whereby – in the event of another mishap – the investment banking bit can collapse without dragging down depositors, borrowers and the economy at the same time. These arrangements are known as ‘living wills’.

It is not walls but swing doors that separate the world of politics and banking. People wander out of one into the other all the time even if there might be chanting anti-banking, anti-capitalist groups protesting outside the windows.

Dividend yield and dividend expectations

That is evidently the conclusion of the consensus market of banking share forecasters. The majority of the consensus estimates for the dividends of the FTSE100 banks, with the exception of Standard Chartered, show them as growing.

Below are the market consensus estimated dividend yields for last year (2014), this year and next year:

HSBC: 5.3% for last year; 5.7% for this year; and 5.9% for next year.

Barclays: 2.3% for last year; 2.9% for this year; and 3.8% for next year.

Lloyds: 0.75% for last year; 3.1% for this year; and 4.7% for next year.

RBS: nothing for last year; 0.4% for next year; and 1.55% for next year.

Standard Chartered: 5.7% for last year; 4.4% for this year; and 4.6% for next year.

Share price versus book (net asset) value

Price to book is the classic value investor measure of basic equity value against price paid. Below I provide recent reported price and estimated book figures for the main UK banks (all these are reported figures):

HSBC: at a share price of 586p, a book value of a reported 624p.

Barclays: at a share price of 383p, an estimated book value of 363p.

Lloyds: at share price of 88p, an estimated book value of 70p.

RBS: at a share price of 361p, an estimated book value of 495p.

Standard Chartered: at a price of 1,022p, an estimated book value of 1,206p.

GDP Gearing

Banks as lending institutions gain both operationally (more activity) and financially (higher interest rate margins and lower bad debts) from rising economic activity. As ‘investment banks’ they like to think they can benefit from either growing or shrinking economies, by use of hedging through financial derivatives earning them the sobriquet Masters of the Universe. (I only add that when a banker rules the universe, rather than God or physics, we are likely to be in for trouble. An imploding economy is one thing but an imploding universe would be something else entirely.)

Are banks geared to economic growth or decline?

The UK economy seems to be in strong form to judge from recent motor vehicle production and labour market statistics. The latest consensus economist forecasts are for UK GDP growth of 2.4% this year. Still the world’s largest economy, US GDP is forecast to put on another 2.3% of growth this year. For China, which is trying to build a large consumer and industrial economy, the estimate is for growth of 7%. If the Euro area does achieve the forecast 1.5% GDP growth this year it will add its own more modest contribution to a healthier picture of economic activity.

Bedtime conclusions

My head and heart aching after thinking about banks and bank shares for so long, I climb the steps to the veranda of my Limpopo bungalow. As I slump into deck chair, coconut shell in hand, Polly the parrot appears for some evening conversation. I explain about the banks, and she replies:

“Ok, what do I do?” referring to her own portfolio of shares, naturally!

There is something about her manner which makes me think that she may have been drinking in my absence, when I was dutifully thinking about banks. The wrong sort of attitude, I think. I lean back, give her a long questioning gaze and make my fermented jungle juice fortified reply:

“In a market of high price earnings ratios and low asset backing, bank shares have clear relative fundamental investor attractions. Their valuation is still coloured to some extent by the fears of past events as well as the ongoing crime and punishment routine between banks and regulators which, like the old Windmill Theatre, Piccadilly, never seems to close. To judge from the low yields on short maturity gilts, no one is expecting, either here in the UK or in the US, that short term interest rates are going to rise too fast to kill off recovering economies. Moreover, the Euro version of quantitative easing is in its early rather than late stages.”

I glance at Polly. Her eyes are beginning to glaze over but I attribute that more to her obvious intake of fermented jungle juice than my clearly scintillating explanation of banking facts and probabilities.  I continue:

“You have two clear choices on the London Stock Exchange. There are the more diversified international bank shares like those of HSBC and Barclays and Standard Chartered, which tend to be selling at well below the “book” asset value figure. And then there are the two now largely domestic facing banks, Lloyds and RBS, which have been largely shorn of their earlier investment banking activities, are lower yielding and sell at a premium to the book value of net assets.”

Polly by now has fallen over but retains a serious expression and a strong clawed grip on the cocoanut shell. Her eyes are still open in a swivelling sort of way so I continue, expecting to still reach her inner avian consciousness.

“The first question is this: Which are riskier with greater dividend unfriendly regulatory hurdles, the international brigade of HSBC, Barclays and Standard Chartered, with attached investment banking wings, or the home fires loving Lloyds and RBS?

The second question is this: Which look better value in terms of dividends and assets in a bird in the hand approach?”

Polly nods at this point.

“The fact is that no one knows the answer to the first question about risk. Whatever that is, it seems to be discounted to some extent or another by the high dividend yields and asset backing. So on that simple basis of value, HSBC and Barclays appear to be the better fundamental value buys.

The fact that Lloyds has both lower asset backing and dividend yield tends to suggest that its shares may be relatively overpriced to some extent or that possibly they have too little capital. One or the other. In the good old days banks often had rights issues from time to time to cope with bankers’ bad luck in lending. Ironically, in those days Lloyds seldom did; under Brian Pitman, CEO the bank was run for cash and avoided empire building.”

By now my parrot and best friend Polly is snoring, as I shall soon be. Before then I glance at the share price chart for an indication of what might happen next. They all look fairly close to previous share price support levels or trend line support. Around 260p, I guess for Barclays; around 550p, my guess for HSBC; around 85p, my guess for Lloyds; around 340p for RBS; and around 960p for Standard Chartered. Chart reading may be called technical, but it is always a subjective art, so have a look at the chart yourself. Don’t forget we are in summer thin markets even after many brokers have left for the sun tanning of those dark pools loved by institutional dealers. Goodnight!