Qualiport

[ July 3, 2000 ]

Winning Banks

By Bruce Jackson (TMFGoogly)

Melbourne, Australia -- How do you value shares? There's plenty of answers to this conundrum, but unfortunately no definitive answer. But that doesn't mean you shouldn't give it a try -- the Motley Fool has a 12-part series addressing that exact subject, which should at least help push you in the right direction.

Valuing shares can involve delving into the world of discounted cash flow techniques and long-term earnings projections. They will help give you some fix on a company's true valuation, yet will inevitably be wrong. That's because you're always looking into the future when valuing a company, and try as we all might to think we can accurately forecast the future, we can't.

Why do it then? As I've said on plenty of previous occasions, the price you pay for a share of a company ultimately determines the long-term returns you can expect. Pay too much, and your returns will suffer. The Qualiport has learnt this lesson to its expense -- paying 33 times earnings for Unilever (LSE: ULVR) was a moment of madness.

The last two Qualiport articles have simply and succinctly placed a value on the shares of Lloyds TSB (LSE: LLOY). I like simple answers to simple questions. We can now say that the true value of a Lloyds TSB share is about 630p. Your Qualiport managers are conservative souls, so we could well be erring on the side of safety. Nothing wrong with that mind, as minimising the downside is the hallmark of any good investor.

The Poll Results

On Friday, Maynard concluded his look at Lloyds TSB by inviting your feedback in the form of a poll. When asked what you thought about Lloyds TSB, you conclusively chose "a good company, but must only be bought at 'good value'".

Lloyds are the pick of the banking crop, although Royal Bank Of Scotland (LSE: RBOS) are not too far behind. How do I know that? I've been following the sector for quite some time, having written about it in Industry Focus 2000. Through experience, I know what makes a bank a good investment. It's usually:

• a good record of profit growth.
  
• a high return on equity.
  
• a low, and getting lower, cost-to-income ratio (banking's version of the operating margin).

All the above give you a fix on how well the bank is managed. They also give you an indication of the bank's culture. I like to give the example of NatWest Bank -- its cost-to-income ratio was much higher than most of its competitors (that's bad!), and try as the management of the bank may like, they never managed to bring it much lower. That's most likely because NatWest didn't have a culture of being cost conscious. Lloyds does, and that's why it is still a growing and independent bank, and NatWest isn't.

Information

Where do you find the above facts? The information which will tell you a bank's past profit record, its return on equity, and its cost-to-income ratio? It's all in their annual reports, available on each of their websites. Set up a simple spreadsheet, listing those vital statistics for each bank you're interested in. You'll soon see a picture emerging, one where the cream will come to the top. Those are the few banking institutions to concentrate on.

No Shortcuts

Those of us who invest our cash in the stockmarket do so because we want to be wealthy. Rich. Most of us want to get rich quickly, and with as little work as possible. But why should there be shortcuts to wealth? When it comes to our jobs, we're prepared to work hard, and spend time a lot of time at it. If we save well, we will ultimately become wealthy. Yet we want the opposite when it comes to investing success.

The blunt answer is that there are no shortcuts to stock market success. It takes time to learn about the intricacies of the market, and to ultimately choose winning investments. The banking sector is no exception. Experience and hard work will hopefully ultimately lead to stock market wealth.

The Bottom Line In Banking

Banking is a very competitive business. Each bank has little in the way of a competitive advantage. Why, therefore, is the Qualiport invested in a bank? Well, courtesy of the recent Scottish Widows purchase, we think Lloyds is operating in an organic growth market -- the provision of long-term financial savings products. Coupled with its superior core banking returns, we think it makes a good long-term investment.

When making an investment in a bank, the bottom line is always the price paid. You must buy when others are selling. Ideally the price to earnings ratio (P/E) must be 12 or below, the lower the better, provided of course you're looking at a quality bank. The Qualiport initially paid 755p for its tranche of Lloyds TSB shares, which in hindsight was too much. Another very valuable lesson learnt. It's a lesson Qualiport followers know well too, as signified by your voting preferences.

Finally, great investors buy when others are selling. As TMF Essex says in this post, there's some bearish sentiment surrounding the sector at the moment. However, LarryDuff counters with this excellent reply. Who's right? Time will tell, but often fortune favours the brave. At 624p, Lloyds TSB trade on a forecast P/E of 11.2.

Your Say

-- Cast your vote in the Lloyds TSB poll.
-- Post your thoughts on the Qualiport discussion board.

Where Next?

-- Industry Focus 2000 -- 14 highlighted companies from 14 different sectors. Available now from FoolShop
-- How To Value Shares -- Valuation heaven