As Profits Surge, Is It Time To Buy The Challenger Banks? Secure Trust Bank Plc, Arbuthnot Banking Group Plc, Virgin Money Holdings (UK) PLC, OneSavings Bank PLC & TSB Banking Group PLC

Do challenger banks deserve a place in your portfolio? Secure Trust Bank Plc (LON: STB), Arbuthnot Banking Group Plc (LON: ARBB), Virgin Money Holdings (UK) PLC (LON: VM), OneSavings Bank PLC (LON: OSB) and TSB Banking Group PLC (LON: TSB)

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HSBC’s full-year 2014 results really showed how big banks are struggling in today’s business climate. Rising regulatory costs and fines are really starting to hurt global banking giants like HSBC.

What’s more, consumers are increasingly turning their backs on big banks favouring smaller, challenger banks instead.

The largest public challenger banks in the UK are Secure Trust Bank (LSE: STB), Arbuthnot Banking (LSE: ARBB), Virgin Money (LSE: VM), OneSavings (LSE: OSB) and TSB Banking (LSE: TSB).

All five of these banks are reporting rapid growth and look to be better investments than their larger peers. 

Rapid growth 

Arbuthnot Banking is a holding company for Secure Trust Bank and the Arbuthnot Latham private bank.

Secure Trust is a pure retail banking play and consumer seem to be attracted to the bank’s offering — lending volumes expanded 75% during 2014.

On ‘Black Friday’ the bank saw a 1300% in retail finance applications and 600% increase in new business written compared to the year-ago period.

And thanks to these impressive rates of growth the City expects Secure Trust’s pre-tax profit to expand 61% over the next two years. At present the bank is trading at a forward P/E of 16.4, based on predicted 2015 earnings. 

As mentioned above, Secure Trust is part of the Arbuthnot banking group. As well as Secure Trust, Arbuthnot operates a private bank, which when combined with Secure Trust becomes a formidable force in the banking industry. The group’s pre-tax profit for the first half of 2014 jumped 368%. Profits at the private bank rose 70%. 

If you’re looking to invest in Secure Trust but don’t want to pay a high price, Arbuthnot could be a better bet. The group is currently trading at a forward P/E of 15.7 for 2015, falling to 12.5 for 2016. EPS growth of around 30% per annum is expected for the next two years. 

GARP

Like the Arbuthnot group, Virgin Money is also growing rapidly. According to City figures, the bank’s shares are currently priced at a level that offers growth at a reasonable price.  

Indeed, the City expects the company to report EPS of 21.9p for 2015, which implies that Virgin Money is currently trading at a forward P/E of 14.4. Additionally, City analysts expect the bank’s EPS to jump by 52% during 2016.

On that basis, the shares are currently trading at a PEG ratio of 0.2 showing that Virgin Money is severely undervalued based on its projected growth. 

No contest

Unfortunately, while TSB’s smaller peers are charging ahead, TSB is struggling. 

As it completes the separation from parent Lloyds, TSB’s costs are rising and as a result, the bank’s EPS are set to fall 44% during 2015. However, TSB is expected to return to growth during 2016, when analysts expect the company to report EPS growth of 50%.

Nevertheless, considering the fact that TSB’s EPS are set to slide this year, the bank’s valuation of 20.2 times forward earnings seems excessive. 

Bargain valuation 

OneSavings Bank is by far the cheapest play on the challenger bank sector. 

And with a return on equity of 30% reported for the first half of 2014, it’s difficult to see why. Underlying profit before tax jumped by 400% year on year for the six months ended 30 June 2014. These figures show that OneSavings is certainly one of the banking sector’s better picks. 

According to current figures, OneSavings is currently trading at a forward P/E of 9.2. Analysts expect the bank’s EPS to expand 14% during 2016 and on this basis the bank is currently trading at a 2016 P/E of 8.1. OneSavings is expected to offer a dividend of 6.3p per share to investors this year — a yield of 2.8% at current levels. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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