UK Banking Sector outperformance set to continue into 2013

The Great Financial Crisis, which started in the U.S. in 2007, but rapidly spread to Europe leaving a massive trail of destruction all over the global economy, was especially lethal inside the banking sector.

Banks had been prospering for many years as they extended ever greater credit into a buoyant global economic backdrop – a backdrop that had largely persisted since the mid 90’s. They also benefitted from the extensive financial de-regulation that occurred in Western economies and that allowed them to embrace ever more risk and leverage. Ultimately however, the party came crashing down with a number if banks including once seemingly impregnable Lehman’s and Bear Sterns in the US going to the wall or being bailed out.

In the UK, in order to avoid bankruptcy, HSBC and Barclays had to raise funds from private investors whilst Lloyds and RBS needed a hand from the UK Government. 2008 was a particularly black year for RBS which lost an astonishing 85% of its market value. Lloyds and Barclays were also not spared and both lost around 70% of their value. After covering their wounds with dressings, Barclays and HSBC recovered from losses in 2009 whilst RBS and Lloyds take another year, but they were all punished again in 2011 just when everyone thought the crisis was over…

During the current year, most of these banks are actually back producing profits and as a result the sector has been one of the best performers in 2012 with a gain of 26%. Recovery seems to be well and truly under way but this year’s outperformance still has a long way to go to repair the damage of the GFC as the sector is still down around 63% since the beginning of 2007.

The table above lays bare the picture of destruction within the sector. The banking sector lost more than 20% in 2007, followed by a massive 57% loss in 2008. At that point, most value had already been destroyed and when in 2009 the sector recovered, posting a gain of 24%, everyone was anticipating a recovery that didn’t solidify as the sector was hit again in 2011 after a flat 2010. This hit many hedge funds and money managers around the world, and in particular John Paulson who gave back a good chunk of the phenomenal gains he reaped during the 2007 & 2008 with his famous bet on the sub-prime implosion in the US and that personally reaped him billions.

The banking sector was at the epicentre of the financial earthquake and is the second worst performer since 2007, beaten only by, intriguingly, industrial metals but the headline sector returns mask a wide discrepancy in individual performers with the Asian orientated banks being the best performers… Let’s take a brief look at each of them.

Standard Chartered

Standard Chartered’s operations are concentrated in the Middle East and Asia and the bank largely escaped the financial crisis. Profits have in fact been growing steadily since 2007 and so explains why this is the bank with the best performance during the period since 2007. It is not only the best performer but also the only positive return within the banking sector and a performance that beats also FTSE 350. The bank was severely hit this year when it became the target of the U.S. regulator during the summer (http://www.spreadbetmagazine.com/blog/2012/8/7/standard-chartered-overview-and-trade-update.html). Notwithstanding the summer hiccup, Standard Chartered seems to be on the right path for the longer term and at an operational level and balance sheet quality basis, less risky than others.

HSBC

The second of the Asia focused banks, HSBC has been also able to keep profits in the green right throughout the crisis even though it had to raise some extra equity to fund operations. Earnings per share were hit in 2008 and in the following years, but are now rising back to pre-crisis level. Although the bank shares are still down 24% since 2007, volatility in the stock is much less than for the other banks as again balance sheet quality (bad debts) is much better.

Lloyds

Lloyds was one of the two bailed out UK banks. In 2008, the UK government injected cash into the bank to avoid bankruptcy as it was not able to raise the necessary funds from private investors. The UK government initially had a 43.4% stake in the bank and that was diluted slightly during 2009 but still represents around 40%. Earnings per share are now expected to be in positive territory for 2012 & 2013 but still much less than what the bank was earning before the crisis – a tale of just how much the crisis knocked them considering that Lloyds now owns HBOS and so is in effect, two combined banks. Nevertheless, this is one of the banks that trades at a heavy discount to book value and also due to the Government stock overhang and so now well positioned for recovery. The share price is up 65% this year but still down 85% since 2007 in a stark illustration of the magnitude of those falls at the outset of the GFC.

RBS

Royal Bank of Scotland holds he wooden spoon as the worst performer since the GFC –  a legacy of Fred Goodwin’s monumental mis-management. In 2008 alone, the bank lost 87% of its share value and it is still 95% down since 2007. This year things have started to look a little brighter but the future is still uncertain given the size of the Government’s holding and the overhang this is creating. It is no surprise the bank lost 87% in a single year as it reported record losses of 426p per share in 2009, amounting to a total of more than £24 billion. The UK government had no other option than to acquire almost all the shares of the bank in a de-facto nationalisation that cost a staggering £45 billion. The Government bought shares at around 500p (50p at the time, before the bank had a 1:10 split), and even today it is still losing around 45%.

Barclays

Barclays is a bank that deserves some credit as it fought hard against a government bailout and was able to avoid it courtesy of royal friends in the Middle East. Dividends were also cancelled and Barclays was able to largely carry on business as usual although profits were severely hit in 2008 but are now recovering well. The bank has not done as well as HSBC or Standard Chartered but is still performing better than RBS and Lloyds.

The Future

The UK banking sector is still fragile but not anywhere as a few years ago. This crisis proved longer lasting and worse than even the most pessimistic forecasters thought and its aftermath changed the whole banking sector. RBS, once one of the biggest world banks, is now in a much more modest position while Standard Chartered has seen its position in the UK elevated to the second largest by market cap.

If other countries are any guide to the future, for example the Scandic crises of the early 90’s , as the financial crisis issues of bad debt provisioning diminishes, banks tend to outperform other sectors. This has been the case so far this year and will probably continue this way into 2013 and 2014 as the discounts to book values continue to reduce. In this respect we suggest that speculative buys in RBS or Lloyds are likely to outperform the sector although out of the two RBS is the fragile and has a very large stock overhang to contend with. Barclays perhaps offers the best of both worlds. It still trades at a decent discount to book value, and is better positioned than both RBS or Lloyds from a provisioning perspective and doesn’t have to contend with the Government holding overhang. Any weakness in the stock is likely to be a good opportunity to get long.

Filipe R Costa