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Is that huge valuation discrepancy justified? In years gone by, banks have traditionally traded at a discount to the overall market. That's all due again to their cyclical nature. As the economy goes boom, especially the housing market, in the past banks have been only too willing to fuel that boom by throwing money (mortgages) at people almost regardless of their credit-worthiness and ability to repay. Inevitably, when bust comes, the housing market collapses, companies make redundancies, and banks are left holding lots of sets of keys as consumers throw in the negative equity towel.
Last year, the Motley Fool picked up the Creative Freedom Best Electronic Media award. Here's a link to the post celebrations write-up of the glitzy event.
Nominate here.
Why is it so?
Banks are seen as very cyclical beasts, meaning their earnings rise and fall largely in line with the underlying economy. When things are looking rosy, banks prosper as consumers rush to buy houses, replace that old and tattered carpet, and treat themselves to a new kitchen -- all "big ticket" purchases, usually funded by a bank loan. On the other hand, when the economy turns, and recession hits, as a nation we collectively pull our spending heads in. As a consequence, banks lose business, and that leads to depressed earnings.
Banks are often thought of as difficult to understand. One look at a full set of accounts does nothing to dispel that myth. However, in simple terms, they are money brokers. As a saver, I deposit my cash with a bank, and in return they pay me interest. As a borrower, I borrow cash from a bank, and in return I pay them interest. With savings rates on your average UK High Street bank account struggling to get much above 1%, and average mortgage (lending) rates of 6% and above, it's easy to see how banks can make quite a bit of money out of your average consumer. And as for those dastardly credit cards, some with punitive interest rates of about 18%, they are effectively a get rich free scheme for the banks.
The stock market is always looking forward. It doesn't care about how well, or not, a company performed last year. As far as it is concerned, last year is about as relevant as a company's performance in 1984 -- it clearly doesn't matter. Having said that, I still believe a look back at a company's past performance gives one an indication of what you can expect from their management in the future. Of course, if a company's future growth prospects have all but dried up, the best management in the world won't be able to replicate past growth records.
What about the future growth prospects for banks? Consumers can only save and borrow so much, and the domestic population is growing at a snail's pace, so one could easily conclude that banks' future growth rates will hardly set the world on fire. With Internet and general Information Technology (IT) companies seemingly having almost unlimited growth prospects, it's no wonder that banks are trading on such a lowly rating, as the table shows.
Bank P/E Yield
Abbey National 9.4 5.4%
Bank Of Scotland 12.2 2.2%
Barclays 10.1 3.5%
Halifax 10.5 4.0%
HSBC Holdings 18.6 2.9%
Lloyds TSB 12.5 4.4%
Natwest 12.2 3.7%
Royal Bank Of Scot 10.4 3.4%
Standard Chartered 23.5 2.7%
Simple Average 13.3 3.6%
FTSE 100 28.3 2.2%
P/E = Price to earnings
Yield = Dividend yield
Numbers based on prospective earnings and dividends
(usually for the year ended 31/12/99).
FTSE 100 numbers are historic.
That scenario usually leads to banks making losses. Their profit margins are actually quite low, and it takes only relatively few debts to go bad for a bank to move into a loss situation. Whilst the last real boom and bust in the UK was in the late 1980s and early 1990s (last century!), recently the Asian economies have been through a rather large wobble. That reflects in the performance of the banks exposed to that economy -- HSBC Holdings (LSE: HSBA) saw profits fall 18% in 1998 (although they are forecast to recover strongly in 1999 and 2000), and Standard Chartered's (LSE: STAN) profits stumbled 15% in 1998 and are forecast to have fallen a further 33% in 1999. Ouch!
At the moment, the stock market is looking at higher interest rates. It is looking at rising house prices. According to the Halifax, house prices improved by 13.6% in 1999. With base interest rates at 5.75%, that discrepancy is clearly unsustainable if we are going to get anywhere close to the government's long-term inflation target of 2.5%. The market is also looking at an increasingly competitive environment, one where upstarts like Standard Life can grab 10% of the new mortgage market in their first year of operation. Finally, regulation fears continue to dog the sector, with the government indicating it would like to see more competition. All this adds up to a less than rosy outlook for the separately quoted banks.
Despite the gloom and doom of the above paragraph, banks actually do have some future growth prospects. Cost savings and even some revenue enhancement benefits from mergers and acquisitions, Internet banking, and personal pensions are all potential growth areas.
Being cyclical stocks, it has always been thought the time to buy banking shares was when interest rates have peaked. The only problem with that thinking is that no-one knows when they are going to peak, or at what level. If the housing market gets completely overheated, as it did back in the late 1980s, who's to say we may not see a return to interest rates of 15%? Having said that, double-digit interest rates look highly unlikely in this economic cycle, with most pundits predicting a peak of 7% towards the mid-to-latter part of this year. That of course is very dependent on us consumers not creating a new century housing boom. No gazumping please!
It seems the market has very much factored forward interest rates of 7%, and a little more to boot, into the share prices of the majority of the banking sector. Over the past 5 years, earnings growth has been remarkably consistent, with many of the better managed banks (and this most definitely excludes Barclays (LSE: BARC) and National Westminster (LSE: NWB)) showing consistent year on year growth. Abbey National (LSE: ANL), for example, has achieved a compounded annual growth rate (CAGR) of 14.1% in earnings and 18.7% in dividends. Does it deserve to be on a forward P/E of 9 and a yield of 5.4%?
Investors who are willing to go against the crowd, and believe economic conditions will remain largely stable, could well benefit from having a closer look at some selected banking shares. Of the bigger banks, as well as Abbey National, both Scottish banks -- notwithstanding the uncertainty surrounding their separate hostile bids for NatWest -- Halifax (LSE: HFX) and Lloyds TSB (LSE: LLOY), the latter of which I'm already a shareholder, potentially look attractive at these levels. It may be too late to buy them when interest rates actually do peak.
Related links
Addendum
This year, I am a judge, specialising in the Electronic Media department, and the Creative Freedom Awards are currently inviting nominations to their site.
Nominations should reflect the aims of the Creative Freedom Awards:
If you could also send directly to me (TMFGoogly@aol.com) any suitable Electronic Media nominations, it would be much appreciated.