Will The UK-Focused Banks Soar In 2015? Barclays PLC, Lloyds Banking Group PLC And Royal Bank of Scotland Group PLC

One school of investing thought is to look for bargains in sectors beaten down by bad news, setbacks and poor investor sentiment. There is surely no area of the stock market that’s been more consistently pummelled in recent years than the banking sector.

So, are we seeing the banking industry poised to recover and shoot the lights out during 2015, or is an investment now a high-risk proposition with potential to go either up or down?

A third way

Maybe neither option is likely in the medium term. Perhaps banking shares such as Barclays (LSE: BARC) (NYSE: BCS.US), Lloyds Banking Group (LSE: LLOY) (NYSE: LYG.US) and Royal Bank of Scotland Group (LSE: RBS) will simply remain mired in the mud and deliver a flat total return for investors over the coming years.

The industry’s propensity to misbehave is crystal clear. If you’ll excuse the euphemism, one misdemeanour after another seems to flow to the news lines. We’ve been seeing market manipulation and customer abuse on a grand scale. Mostly, such bad behaviour seems to stem from greed, and there appears to be growing political will to rein in such excesses in order to put the banks back in their place, as facilitating organisations to support business and personal finance.

Greater regulation, legislation requiring higher capital reserves, extra taxes and constraining rules all stymie a bank’s ability to earn its riskier returns, and for good reason. There’s no doubt that dodgy, high-risk banking and investing practices caused last decade’s credit crunch and its aftermath, the great recession. However, the increased regulatory focus on the banking industry is a powerful current against any investment in the sector.

That’s not the only problem

As a UK citizen, I’m cheering on the regulators who, apparently backed by public opinion, seem to seek an emasculated banking and finance sector capable of supporting UK economic activity without stepping out of line. I’m all against fat bonuses and diabolical directors’ packages; I despise crafty customer charges and abhorrent interest rates. Yet, as a potential investor in banks, I recognise that stiff policing works against outstanding earnings’ growth.  

But that’s not the only problem. There’s a fundamental challenge with bank investing that applies even when the banks behave. Banks, and other financials such as insurance companies, are amongst the most cyclical of all firms. Share prices, profits and cash flow in the sector are likely to rise and fall in line with the macro-economic cycle. That means that we should consider firms such as Barclays, Lloyds and Royal Bank of Scotland in terms of their cyclicality above all else, before there recovery potential, before their dividend promises and before their earnings’ growth prospects.

Cyclicality can really mess things up. When we think a cyclical looks cheap on conventional valuation indicators, such as dividend yield and P/E ratios, we might be seeing a perfect time to sell rather than to buy. If you were investing pre-credit-crunch you’ll remember the banks appearing on value lists as ‘square shares’, meaning the high dividend yield equalled the low P/E rating, all traditional good-value stuff. What followed was a calamitous plunge in profits and share prices as the macro-cycle dipped. When profits start to improve with the banks, their valuations tend to gradually contract in anticipation of the next macro-economic collapse. As the cycle unfolds, that compression effect can work against total returns for bank investors. On top of that, there’s a sting in the tail when earnings do collapse again. Investing in the banks, mid-cycle, as now, is a high-risk proposition in my view.

What next?

The toughening regulatory landscape, and valuation compression due to cyclicality, are two factors that render traditional valuation indicators and estimates of forward earnings practically useless to the bank investor. The question then becomes, “should we ever invest in a bank?” The answer, in my view, is maybe immediately after the shares have fallen hard, but not now, and only ever if you have a high risk-tolerance.

I reckon, conservative, long-term investors should avoid banks like Barclays, Lloyds and Royal Bank of Scotland. Medium-term total-return investment returns look uncertain and limited at best, while the downside risk remains huge. So, I'm looking at other opportunities on the London stock market. A new exclusive wealth report from the Motley Fool is a handy companion in my search.

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Kevin Godbold 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.