Is now the time to buy bank shares?

Our writer considers whether bank shares could be a bargain buy for his portfolio right now — or a potential value trap.

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Some of the country’s biggest listed companies are banks. Barclays, HSBC, and Lloyds are among the 20 shares with the biggest market capitalisations on the London stock exchange. A worsening economic outlook has pushed some bank shares down. As a buy-and-hold investor, should I use this opportunity to load up?

Bank shares and the economy

Unlike some sectors, the link between banks and the wider economy is obvious. Banks circulate the lifeblood of the economy: money.

When the economy does well and people are flush with cash, banking businesses tend to perform well. But if there is a recession, loan defaults tend to increase. Bank profits can suffer dramatically. During the last financial crisis, Natwest (then called Royal Bank of Scotland) reported an annual loss of over £24bn.

Warning bells have started to sound once more on the economy. Inflation is surging. The Bank of England expects a recession before the end of the year. That may explain why some bank shares have been falling. In the past year, Lloyds is down 8% and Barclays has fallen 9%.

It has not all been red ink, though. Natwest has risen 9% and the more internationally focussed HSBC is up no less than 31% over the past 12 months.

Are valuations attractive?

Using common valuation methods like a price-to-earnings (P/E) ratio, some bank valuations currently look cheap. Barclays, Lloyds, and Natwest all have P/E ratios in single figures.

But as the economy worsens, earnings could slide. So those ratios may not be what they seem.

Lloyds and Natwest saw their earnings grow in the first quarter compared to the same period last year, although Barclays reported declining profits. There were mixed signs about a weakening outlook. Lloyds took a charge based on changing its economic forecast. But Natwest actually released some money it had set aside, as defaults were lower than it planned. It still noted that “the economic outlook remains uncertain”.

Each bank has a different mix of business. So far, default rates broadly seem normal or even better than expected. But an uncertain economic outlook makes it hard to value bank shares, in my view.

So far this year, not a single Barclays director has bought shares in the bank on the open market. But its chief operating officer, chief compliance officer, and chief risk officer have all sold shares. At Lloyds and Natwest, there has been some director buying, although in both cases on a markedly smaller scale than director selling. Directors buy and sell for a variety of reasons. But the recent prevalence of sales over purchases does not inspire me with confidence in how those directors see the outlook for their own banks.

Weighing my move

Valuations do seem potentially attractive to me. But for that to turn out to be true I think bank earnings will need to hold up strongly.

That could happen. There were various encouraging signs of economic resilience in many banks’ first-quarter earnings.

But the wider economic picture could bode poorly for bank shares. To buy shares, I like to feel confident in their long-term business prospects. I am therefore paying close attention to the overall economic picture and any sign that it is impacting likely bank profits.

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 considered so you should consider taking independent financial advice.

Christopher Ruane owns shares in Lloyds Banking Group. The Motley Fool UK has recommended Barclays, HSBC Holdings, and Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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