MARKET COMMENT
Banking On A Recovery

By David Kuo (TMFDragon)
October 10, 2001

Carburton Street, London -- Three months ago, Stuart Watson (TMF Tiger) looked at the banking sector and suggested that we brace ourselves for the their collective reporting season. The banks duly delivered and their earnings were every bit as good as investors expected. At the time, the market was predicting a protracted period of low inflation and perhaps even a few more interest rate cuts to help boost economic growth. Low inflation, low interest rates and sustainable economic growth are the main ingredients that allow banks to make heaps of money. But how likely is this to continue?

The outlook for businesses has changed dramatically since Stuart's article. The events of September 11 have now created a business environment where greater uncertainty prevails. There are concerns that some banks might have to set aside more provisions for bad loans and this could result in lower profits in the future. There are also fears that some of the world's major economies could slip into recession and that this recession could be deeper than expected. The combination of fear, uncertainty and risk could, in turn, translate into lower share prices for the banking sector as a whole. But all this could be a good buying opportunity for astute investors.

As investors, we are constantly making investment decisions in the face of risk and uncertainty. The greater the level of uncertainty, then the greater the margin of safety investors will demand before they are prepared to invest in that business. Currently, the average price to earnings (P/E) ratio for the banking sector stands at 16, a rating that implies an earnings yield of 6.25%. The forward P/E for the sector would suggest a ratio closer to 13, producing an earnings yield of 7.9%. This is a relatively attractive valuation when we consider 10-year gilts are yielding just 4.8% and the main market has an overall earnings yield of 5.2%.

Banks operate within a cyclical sector and their valuations are a reflection of how investors see the economy in the future. Currently, bank shares are flirting with valuations that are low when compared with historical averages. For the long-term investor, this is a good time to revisit the industry and review likely investment candidates.  

Where Next?

Banking sector discussion board.