VALUE INVESTING
Banks Are On The Verge Of Value

By Stephen Bland (TMFPyad)
July 12, 2002

I'm not averse to investing in a good bank now and again as a substitute for the real thing, namely a short-term value play. Banks are often the first in and first out of a bear market. They can be attractive, fast-moving shares and the large falls of recent days illustrate this. The same will happen in a recovery situation when experience leads me to believe that they will power up at the start of the eventual recovery, although I have no idea when that might be.

I indicated a few tell tale signs in a recent article. Beware of a few voices telling you we've hit bottom, can't go any lower. The earliest callers are always wrong. But when you hear near unanimity that the market has much further to fall then you know that it likely does not have much further to fall. However, markets as such are of little interest to dedicated value players, it is individual shares upon which one's focus is concentrated.

Of the eleven banks listed in the UK, seven have fallen by more than the market in the last month illustrating the relative weakness demonstrated by this sector in a raging bear market. In increasing order of relative weakness, the three worst are Royal Bank of Scotland (LSE: RBOS), Barclays (LSE: BARC) and the awfully named HBOS (LSE: HBOS) which is no relation to the similarly named and equally awfully chosen title HSBC (LSE: HSBA). HBOS has fallen by 8% more than the market in the last month.

Turning to the critical fundamentals though, these three are not the cheapest. That honour belongs to Abbey National (LSE: ANL) on dividend yield grounds with a  prospective 7% or so, and to Lloyds TSB (LSE: LLOY) on P/E grounds with a prospective ratio of around 10. Both of these also show relative market weakness in the last month but only slightly. Also note that Lloyds yield is not much less than Abbey's and that Abbey's P/E is not much greater than Lloyds so that really, on these two important fundamentals alone, there is not much to choose between them.

However these two banks differ in the nature of their business, Abbey still being primarily a former building society style, essentially UK-based, mortgage bank and Lloyds being primarily an international business bank. What you read into that comparison is up to you but the risk profiles could be seen as somewhat different possibly.

To make really serious short-term money though, these two are not quite cheap enough yet in my view. Be nice to go for them on a P/E of say 7, which I have stated before is a level at which you can really score if you have the patience to hang on for a bit. It's not that long ago that Lloyds was on a P/E of over 20, a mad rating for a bank. A P/E of 7 implies a fall from now of another say 30% in the share price to 426p, assuming unchanged consensus earnings forecasts. At that level the prospective yield will be almost 9%, again assuming unchanged dividend forecasts.

This doesn't mean that such a fall will occur, I'm just stating the point at which I think Lloyds will be irresistible. And even if it does fall by that much, that doesn't mean it can't go lower still. But you have to hit on it somewhere if you are going to at all, and it is evident that a P/E of 7 and a yield of 9% is very, very cheap for Lloyds. It is a situation that is unlikely to hold for that long and which offers the potential to double or even treble your money over two or three years perhaps, whilst reaping that fat yield from a blue chip share. A low risk/high reward attractive value play in my view, should it ever get down to that kind of level.

Also, I'm not saying that these shares are not attractive short-term bets right now, but personally the odds have to be overwhelmingly in my favour before I buy a share and I don't think these banks are quite there just yet. They are cheap but like with any value play they have to be ultra cheap, not just moderately cheap. You want that extra bit of icing to make the killer play. And it still doesn't guarantee you won't go wrong of course, just that you have reduced the chances considerably of so doing, which is the essence of value investing.