VALUE INVESTING
Banking Value

By Stephen Bland (TMFPyad)
October 4, 2002

As a nation it seems to me that we have too many banks. I make it that there are eleven banks quoted on the London market, then add all those unquoted building societies that crowd our high streets and you arrive at a substantial number of businesses offering the basic banking services of savings and loans.

Course the one you want is never there. I chanced to be in Uxbridge a few days ago which has one of those recently built pedestrian shopping precincts and needed to visit a branch of a building society. I found just about every branch of every bank and building society in the universe from the Aberdeen Teetotallers Mutual to the Zimbabwe Mugabe Swiss Personal, except, natch, the one I wanted.

In desperation I went into an Abbey National and asked sheepishly if they knew whether Uxbridge had a branch of the Old Farts Temperance and was told, translating from the Australian, that no, and the nearest one was in Harrow. I was impressed by this lady's knowledge but figured that she had been asked this question before so noticeable was the OFT by its absence from Uxbridge. I left pondering the question that has troubled philosophers since Socrates – why do you never see blokes working in building societies?

Here is the stuff on the eleven quoted banks in descending market cap order:

                                       Cap £b      Yield%       P/E

HSBC (LSE: HSBA)                          61         5.5       12.8
Royal Bank of Scotland (LSE: RBOS)        38         3.7        8.3
Lloyds TSB (LSE: LLOY)                    28         7.3        8.8
Barclays (LSE: BARC)                      27         4.8        9.0
HBOS (LSE: HBOS)                          23         5.0        9.5
Abbey National (LSE: ANL)                  8        10.1        7.0
Standard Chartered (LSE: STAN)             7         4.8       12.3
Alliance & Leicester (LSE: AL.)            4         5.4       11.3
Northern Rock (LSE: NRK)                   3         3.3       10.7
Bradford & Bingley (LSE: BB.)              2         5.5        9.4
Egg (LSE: EGG)                             1         0.0       36.3

Note that yield and P/E figures are consensus forecasts.

My belief is that banks are now cheap, though not fantastically so, and that in consequence they  may prove rewarding investments for those prepared to hold for a few years. This does not mean of course that they can't get cheaper but you cannot call the bottom. I do not know if they will get as cheap as they were in the bear market of 1974 when they could be bought for a P/E of around 3 in some cases, though note that in those days there was every reason to suppose that they could have gone bust. That was end of the world time and the current bear market resembles that in no way at all, so far anyway.

My call for real cheapness on general banks as I've written before is a P/E of around 7 but they may not get that low in this market. In any case most of them are not far off it now.

There is a natural division amongst these eleven between the general banks and the mortgage lenders. Thus the top five caps are all general banks whilst those below them are the mortgage banks except for the special cases of Egg, the curiously named internet personal bank, and also Standard Chartered, which specialises in international business services. Note the substantial size difference between the mortgage banks and the others, the former are dwarfed by the general banks.

What are the risks? Well apart from the risks of shares in general, I see the mortgage banks as being a little more risky than the others. The reason of course is that their lending is concentrated in one area of business and solely in the UK whereas the other banks are involved primarily in business lending across a wide spectrum of customers both here and internationally. The latter also have a wider range of other services than the mortgage banks though all of them it seems to me are quite heavily involved in life insurance activities. Propping up these insurance subsidiaries that may fall short of legal capital requirements due to the bear market will in some cases cost the parent dear and may involve a hit to earnings in the short term.

Another risk factor is that recession will cause a higher than usual incidence of bad debt for the general banks, hitting earnings. The question is whether this is not already discounted in the price. Markets in general and banks in particular, tend to lead economic activity so as with all value, the time to buy is when things look gloomy, not a couple of years ago when Lloyds for example I recall was on a P/E of over 20. Financial shares like banks and insurers are rapid movers in strong bull and bear markets and will power upwards dramatically from a low point showing large gains in any recovery. The reverse of course can happen from high points as we've seen recently. They are far more reactive than many other market sectors, a feature which I find attractive.

The cheapest of the above in terms of both P/E and yield by far is Abbey National, a mortgage bank that tried to emulate its far bigger competitors by engaging in wholesale banking activities, lost money and was subsequently marked down by the market. The forecast yield of 10% is amazingly high, the market suspecting a dividend cut - which does not mean that one will occur.

The next cheapest is Lloyds TSB on a yield of over 7% forecast, whilst its P/E is roughly similar to its competitors apart from HSBC which for some reason is much higher rated. I don't see much reason why Lloyds should carry a much lower valuation on yield than the others, though some think this may be to do with having to provide additional finance to its substantial life insurance interests. Generally though it seems to me that the high street banks are all much the same really.

After Abbey and Lloyds, which stand out on cheapness, there is a clear gap with the next highest yields being around 5% and lower, combined with P/Es of 8-9 and over.

The attraction of these banks or any value style share really is that whilst waiting for your capital to do the business, you pick up a good yield at the same time. A have your cake and eat it state of affairs if you get it right about the capital value and divis are not cut.

Which ones to buy if you wish to go in? Well, the least risky approach to bank exposure is buy a selection choosing from both the major banks and the mortgage ones. I would tend to weight the selection with more general banks though. If you want to increase risk, and potential reward, I suggest going for the two cheapest, Abbey and Lloyds. But do bear in mind that you will need great patience and must be able to live with potentially serious falls that could easily still occur if the bear market continues instead of stabilising.