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Doomed: A Double Drag Hits Investment Potential For Banks Like Barclays PLC, Lloyds Banking Group PLC and Royal Bank of Scotland Group PLC.

Have you noticed the share-price performance of the banks lately? They’ve been going nowhere for some time.

UK-focused banks Barclays (LSE: BARC), Lloyds Banking Group (LSE: LLOY) and Royal Bank of Scotland Group (LSE: RBS) have seen their share prices mired in the mud for over a year. There’s a good reason for that — two, in fact. The banks face an ongoing “double drag” on their share price progress, which renders them unattractive as an investment proposition.

Escalating regulation

In Britain, the Bank of England’s Prudential Regulation Authority (PRA) has responsibility for the regulation and supervision of banks, building societies, credit unions, insurers and major investment firms. The banking regulation system was shaken up in 2012 with the creation of the PRA after the dismal failure of the previous regulatory regime, which seemingly failed to notice the onset of, let alone prevent, last decade’s bank-induced financial crisis.

All eyes are fixed on the PRA and its performance. The organisation’s primary brief is to keep sharp scrutiny on the firms it monitors to make sure they do nothing to jeopardise the stability of the UK financial system. After what happened before, the PRA will not want to be seen lacking teeth. Yet, since the financial crash, the banks apparently continue to misbehave. The old cultures within banking firms resist eradication like invasive dry rot in old buildings.

Make no mistake about it, the PRA has every reason to bear down on the banks with the full might of its powers in the coming years, and my bet is that it will do just that. The current focus is on capital reserves, with the PRA proposing that firms with significantly weak risk management and governance should hold additional capital in the form of a buffer to cover the risks posed by those weaknesses until they are addressed or until they can show that internal risks are under control.

Such proposals are good for risk management but act as a drag on total returns for those investing in the banks, as money going to capital reserves is no longer available to the banks to invest in growth lines, or to pay out in dividends. Increasing regulation tends to stymie individual banking business’s growth potential, acting as a drag on total-return potential for those invested in the banks.

Valuation compression

The other big problem for the financial sector is its close attachment to general macro-economic cycles. Banks are cyclical to the very core, and that’s what makes them dodgy buy-and-forget investments. Share prices in the sector rise and fall with profits and cash flow in line with the gyrations of the macro-economic cycle.

Valuing banks is tricky. There’s often gradual P/E compression in anticipation of the next peak-earnings event as we travel along the macro-economic cycle. That leads to valuation indicators tending to work back-to-front making the banks seem like good value at precisely the wrong time in the macro-cycle. Buying a bank when the P/E rating is low and the dividend yield is high can be a disastrous strategy, as such conditions can presage the next cyclical plunge.

I think the valuation-compression effect we see with cyclical firms such as banks is the second drag against total investor returns for holders of Barclays, Lloyds Banking Group and Royal Bank of Scotland Group. Valuation compression seems like a major factor dictating the flat share-price performance of those banks over the last year or so.

Looking forward, the double drag of escalating regulation and valuation compression seems set to emasculate the total-return performance of the banks until after we at least see another cyclical bottom.

That's why I'm avoiding the banks and instead looking at firms like these five shares, which make good candidates for further research. They are strong, well placed in their sectors, and exhibit far less cyclicality than the banks.

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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.