VALUE INVESTING
Banking Makes You Go Blind

By Stephen Bland (TMFPyad)
January 21, 2000

As I have often written, for my deep value or pyad shares, I do not go for particular sectors. So before anyone accuses me of failing to keep the faith, this article is not about super value shares where sector is unimportant, but it is about a particular sector.

I do make side bets from time to time in shares which seem to me to be unfairly depressed. These may be my crisis plays or similar approaches where I perceive some profit to be made short term. Not whims – they will always have value-type investment logic – but I would not insist on all the criteria, maybe even very few of them. They will nearly always be blue chips, FTSE 100 companies.

Unless people are blind, it is clear that the bank sector has been in steep decline over recent months. Some of the retail banks – that is, the former building societies – are trading at all time lows. Although I personally have little interest in the market, it is possible in my view that the bank slide may be the beginning of the bear market that we will have to face sooner or later, and which I suspect a large number of our readers have never experienced.

I say this because in a serious bear market, banks are frequently the first to decline. Bank shares are like antennae, picking up signals from the health of the business community. They will be hit hard in a business or property slump through bad debt and simple lack of customers for debt. Rising interest rates, although they are still quite low, are often the cause of bank share falls, as we've seen. But I'm not really making any predictions, just quoting history. Which does not always repeat itself in exactly the same fashion.

I wrote some months ago, both in messages and perhaps, I can't recall, in articles, in response to readers looking at bank shares then, that I advised against it. They were simply too dear. And anyone who knows my style will be aware that there is one overriding cardinal rule that I follow, whether it is pyad shares, or more general crisis or value plays, whatever. It is this:

Never never never buy a share when it is dear.

I know it is tempting. I know all the examples, better than most round here I guess over the years, about shares on a price to earnings ratio (P/E) of 200 going much higher. They do. But with that comes immense risk. Not the sort of risk in which I am interested in the slightest. I take different kinds of risk by concentrating my money, by not spreading it round. By having an egg the size of Texas in a basket the size of the USA.

Bank shares back then were dear. Maybe a P/E of over 20 for the likes of clearers like Lloyds and so on. The retail banks, those whose business is really only mortgage lending, were also high. Interest rates were low. Exactly the wrong time to buy a bank. Yet people were considering growth forecasts for years into the future and justifying the very high P/E as being acceptable in this manner.

Other evidence for me about this sector looking peaky were the bids. Lloyds for the Widows, the Scottish Banks for NatWest. This sort of thing is characteristic of the high points in a bull market. The reverse of what I would do. But I'm no banker. Big companies in general, not only banks, tend to buy dear, and then often make a hash of it. The higher share prices go, the more M&A activity can be seen. The exact opposite of what should happen, of course. Why buy NatWest at 1200 or whatever when you could have got if for 700 a couple of years ago? Value investors they are not.

Banks are commodity products. There is hardly the slightest difference between them. They have nothing to offer comparatively, among themselves. No competitive advantage to speak of. They are not growth businesses in general. How much banking can you do? Thus they try to grow EPS (earnings per share) by cutting costs. You can see the massive numbers of branch closures, the drive to staff-saving electronic banking. Fair enough, but that is not the same as being in some high growth business.

They do not deserve high P/Es. Maybe 12-15 is about right. But that's just my view. The market view for some time has been different. But now it has changed for the time being, demonstrating that banks were overvalued. If you were shrewd you could have traded at the right points and done alright. It is quite possible to make money out of dear shares that get dearer.

But not for most small investors. They lack traders' instincts. Most of them do the opposite, buy dear because of tips; whims; pub talk; general increasing interest in shares due to a lengthy bull market; because they can see the customers; and so on. Then, taken by surprise by the fall, they sell cheap, then swear the market is just a casino and they'll never enter it again. The way they play it, it is.

Like the big companies that tend to bid when shares are dear, for probably the same reasons the inexperienced small guy is attracted to shares when they are dear. Sharply rising prices make good copy for the press. The little guy wants a piece of the action.

Back to P/Es. I personally don't want "about right" when I buy, I want cheap. I would buy a leading bank on a P/E of maybe 7 maximum, depending on how this compares with the market. If the decline continues we will be there. I think Lloyds would perhaps have to halve to achieve this. No problem, it will hit that. So wait if you want to have a bank, we are not there yet. Even when we are there is plenty of time. I am not making a prediction as to when this will happen. But it will. Probably combined with higher interest rates. That's when people should buy banks. And that's when large amounts of money are to be made.

You have to take the risk of shares falling further before they rise of course. Nobody can call the exact bottom except by pure luck. You may buy a bank on a trailing P/E of 6/7 and it halves to 3 in a really exciting bear squeeze. No matter, your judgement will have been right if you have the patience to see it through. And you will likely be receiving a good yield whilst waiting. When the recovery comes, it will drive banks through the roof, doubling or trebling in a year or two. They recover much more rapidly than other sectors, first into and first out of the bear pit. Attractive.

My purpose in writing this particular article is to point out that bank shares can be terrific investments at the right time. The right time being when they are cheap. What prompted me was a thread on the value board started by a reader complaining of the slump in Lloyds shares and asking for reasons. There is only one reason. The shares were too high when our reader went in. He bought dear. A sin, a crime, to the value player. And I don't like to see our readers losing money.

Whichever style of value you adopt, whatever criteria you use, and I cannot repeat this too often, the fundamental approach, our financial DNA, is cheapness. And to identify cheapness you have to know a bit about the market. You have to do some homework. This knowledge does not come for nothing. You have to work at it.

With banks, you have to get to know what the typical long term P/E normally should be and then put in some judgement of your own, like my comments that they are just indistinguishable commodity businesses that hardly have any business being on double digit P/Es. If you decide that in the historical long term they have traded at say 12, then they are overpriced at 24 and cheap at 7. The same would apply to any other sector where you are looking for bargains. But banking interests me because I have a bit of a soft spot for financial shares. The quick reaction to bear markets is one reason for this. Engineering for example is not a fast-reacting sector.

However bear markets are rare beasts and therefore one couldn't make a lot of money on that alone. So although banks were the catalyst, really I just want to convince people, value investors if you like, to avoid buying dear.

Comments on the value board, please.