What’s Wrong With Banking Stocks (And Should You Buy Them)?

2016 was meant to be the year in which UK banks finally made good on their promise of recovery. Yet so far this year, banks have massively underperformed the wider market.

The progress made in strengthening banks’ balance sheets hasn’t been reflected in their share price performance, as these figures show:

Almost all of these stocks now trade at a big discount to their book values, suggesting that investors have serious concerns about banks’ future returns.

So what’s driving this sell-off — fear or fact?

Potential problems

The big worry seems to be that a surge in bad debts will hammer bank’s balance sheets. This would threaten banks’ regulatory capital strength and could leave them forced to raise fresh cash from shareholders.

The prices of bonds issued by banks have fallen in value to reflect these fears, and this has helped drive banks’ share prices lower.

There are certainly some areas of serious concern in the corporate bond market. Bonds issued by many US oil and gas companies are trading at distressed levels. These aren’t just small, junk-rated companies. Some substantial firms with investment-grade credit ratings are at risk.

There’s also a fear that as China’s property boom unwinds and the country’s economic growth slows, bad debt levels could rise dramatically. This is seen as a particular risk for HSBC and Standard Chartered.

That’s not all…

Investors are concerned that banks aren’t sufficiently well-funded to withstand another 2009-style downturn. There’s uncertainty over the impact of regulatory changes.

The outlook for earnings growth also seems to be worsening. For example, consensus forecasts for Barclays’ 2015 earnings per share have fallen by nearly 20% over the last year.

In the UK at least, there’s the nagging fear that banks will face yet more misconduct fines. These have proved to be costly and have damaged investors’ confidence in banks’ ability to deliver reform and growth.

So are the banks a sell?

2009 doesn’t seem that long ago and investors are understandably concerned about the potential for another banking meltdown.

Yet this risk may be overstated. Banks’ balance sheets are much stronger than in 2009. All the big UK banks passed the Bank of England’s latest round of stress tests in December, without being required to raise fresh capital.

These tests include the simulation of a major downturn in China, and the banks’ ability to deal with misconduct fines of up to £40bn!

A contrarian buy?

The banks aren’t absolutely bulletproof. But my view is that the outlook is probably not as bad as current valuations suggest.

I believe that there’s some value in the banking sector, and that most of the major UK banks are worth considering as value buys on a three-to-five-year timescale.

Barclays, HSBC and Lloyds all trade on eight times forecast earnings or less. All offer a forecast dividend yield of 4% or more. A lot of bad news is already reflected in the share prices of these banks.

Now could be the right time for contrarian investors to take a closer look.