VALUE INVESTING
Are Banks Still Cheap?

By Stephen Bland (TMFPyad)
June 27, 2003

I last wrote a review on the bank sector in early March. Although that was merely a little under three months ago, the market has since risen strongly. So it is interesting to see what has happened to banks, perhaps the leading sector in the whole market, judging by the preponderance of its representation in the FTSE100 index.

When I wrote my last article on this, the index stood at 3,563.5 and it closed yesterday, as I write, at 4,067.9 - an increase of 14.2%. I have always maintained that banks are geared to the market in periods of major change so they should have recovered far better than shares in general as the market rose.

Here are the eleven listed banks in descending order of market value. Yields and P/Es are based on consensus analysts' forecasts.

                             Mkt cap    Price   Yield     P/E     Inc%
                                  £b
HSBC (LSE: HSBA)                77.2     716      5.3    13.7      6.9
Royal Bk of Scotland (LSE: RBS) 50.1    1700      3.1    10.6     24.1
HBOS (LSE: HBOS)                31.0     807      3.9    11.4     24.0
Barclays (LSE: BARC)            29.5     452      4.7    10.8     31.0
Lloyds TSB (LSE: LLOY)          24.6     441      7.8     9.8     32.0
Standard Chartered (LSE: STAN)   8.8     750      4.3    13.8      8.9
Abbey National (LSE: ANL)        7.0     480      5.3    21.4     27.0
Alliance & Leicester (LSE: AL.)  4.1     846      5.4    10.9     10.9
Northern Rock (LSE: NRK)         3.1     728      3.3    10.9     12.7
Bradford & Bingley (LSE: BB.)    2.2     337      5.1    10.7     17.8
Egg (LSE: EGG)                   1.0     125      0.0    54.9     30.2

The final column shows the percentage increase since my last article and it can be seen that seven of these banks have outperformed the market, many by a very wide margin. And not only that, but holders will receive a yield way in excess of the market. Consequently, on a total return basis, the advantage is even greater than shown above.

There are two main bank categories within the sector, being general commercial banks offering a full range of services, and the specialised mortgage banks, which tend to be the old building societies. The five largest all consist of the former.

Standard Chartered is a special case, differing from the two main categories of banks in the list. It is neither a general high street commercial bank nor a mortgage bank, but specialises in services for international trade. However you rate the share, it is dear on both P/E and yield grounds when compared against many others in the sector. Whether it deserves this or not people must judge for themselves, but the fact is that it has not taken part in the banking super recovery so far.

The ludicrously entitled Egg is also a bit of a special case. Why anyone would buy this nomenologically challenged, yieldless and stratospherically P/E rated share beats me, but nevertheless it has put in a grand performance, amongst the best in the sector. But then I'm the last one to claim that the stock market is wholly rational. One of those jam tomorrow shares. Me, I prefer my jam today and thickly spread at that.

Of the high street commercial banks offering a full range of services, HSBC has lagged quite a bit. It had a P/E significantly higher than the other major commercial banks at the time of my earlier article and it still does. In other words, amongst the major banks it was those offering the lowest P/Es that delivered the greatest returns. If you believe, as I do, that these banks are essentially the same, then there was, and still is, no reason to buy the dearer ones.

The cheapest bank, Lloyds TSB, has also been the strongest riser in the recovery. Coincidence? No. Lloyds was hysterically cheap when the market was much lower, both against the market and relative to other banks, and is still begging for it after its recent rise on these same two bases. Look at that yield compared with its rivals, and it is on a lower P/E too. And all for no reason in my opinion, other than the usual irrational market conditions that sometimes prevail.

Lloyds is just the same as Barclays and the rest of the major banks. It is not, in my view, inferior in any way, and so does not deserve a lower P/E. This is exactly when the value player has to go in big. And dump when the P/E becomes higher, the yield lower and commentators start telling us that it is attractive.

So where now for banks? Well, as far as Lloyds goes, I still find it the most attractive play in the sector. It's cheap relative to the whole market as well. If the market continues to recover, I expect it to continue to outperform. If the market falls back, the opposite may happen. In the slightly longer term though, I expect holders to be rewarded.

Of the others, Egg stinks from a value viewpoint. Curate's Egg it is not. I can see no attraction in it at all from where I stand. Some might see bid hopes in it, but personally I ignore that. Barclays is probably the next best play after Lloyds amongst the big banks, simply on P/E and yield grounds. As I say, there is nothing else to distinguish them. The Royal Bank of Scotland might be good, but its yield is a bit low.

The mortgage banks have some attractions, particularly Alliance & Leicester, but here you have to believe that there will not be a  housing/mortgage collapse. This occurred at the end of the eighties and early nineties and it will cream these shares if it occurs.

The author holds shares in Lloyds TSB.