The godfather of value investing, Benjamin Graham, made it quite clear that the process of investing is nothing like speculation: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.” On the other hand, speculation is more akin to gambling, with no return guaranteed.
With this in mind, it’s easy to arrive at the conclusion that banks, which rely on leverage and trading to make a living, can never be deemed true ‘investments’ due to the speculative nature of their businesses. And this is the reason why I’m staying away from banks like Royal Bank of Scotland (LSE: RBS), HSBC (LSE: HSBA) and Standard Chartered (LSE: STAN).
Complex balance sheets
Terry Smith was once one of the City’s most respected bank analysts but he now refuses to invest in the sector. Why? Well, one of Terry Smith’s basic tenets is never to invest in a business that requires leverage or borrowing to make an adequate return on equity. Leverage and borrowing is a key part of every modern banks business plans.
What’s more, Mr Smith notes that banks balance sheets have become almost impossible to understand, crowded with complex derivatives, the value of which no one can truly understand and can be changed in a split second. Some analysts believe that both HSBC and RBS have billions in toxic derivatives still in hidden in their balance sheets. Unfortunately, we will not know if this statement is true or not until everything goes wrong.
Of course, there’s also the quality of the assets on each banks balance sheet to consider. For example, Standard Chartered was, until recently, considered one of the best London listed banks. However, a rising number of bad loans within Asia has whacked the bank’s balance sheet, forcing Standard to take impairment charges of $1.6bn year to date and issue several profit warnings.
Mistakes of the past
Aside from the complexity of bank balance sheets, banks are still being forced to pay for their mistakes of the past. Hefty fines being levied by regulators are digging into bank reserves, denting profitability and threatening dividend payouts.
RBS, for example, announced within third quarter results a £400m provision to cover possible foreign exchange market manipulation fines. Similarly, during the third quarter HSBC set aside $1.6bn in regulatory provisions, including $378m to cover potential fines for alleged rigging in the foreign exchange markets. These provisions pushed the group’s overall operating expenses 15% higher during the quarter.
Meanwhile, as well as facing a rising level of loan impairments, Standard Chartered is having to pay a constant stream of fines to regulators following lapses in the bank’s internal systems and controls.
Waiting for change
For the time being it looks as if the tough regulatory environment for banks will continue and bank balance sheets aren’t going to get easier to understand any time soon! So, after taking these factors into account, I’m going to stay away from the banking sector for the foreseeable future.
