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HSBC Holdings plc And Royal Bank Of Scotland Group plc: Will 2016 Finally Be Their Year?

Buying unpopular stocks is never an easy thing to do. However, they can prove to be excellent investments in cases where their valuations are depressed without good reason. Certainly, if their business models are weak or their future outlooks are very disappointing then they can lose an investor considerable money. However, for many stocks that are not currently in vogue, there’s the prospect of significant capital gains for long-term investors who can live with a degree of volatility.

This seems to be the case with HSBC (LSE: HSBA) and RBS (LSE: RBS). Both banks are hugely unpopular at the moment and in both cases, there’s some way to go before they can be viewed as exceptional businesses.

Cuts, cuts, cuts

In the case of HSBC, its cost base has simply risen to a level where it needs to be slashed. The bank’s management team has clearly realised this and is implementing savage job cuts and other money-saving measures that are aimed at generating $4.5bn-$5bn in annual cost savings by 2017. If the bank can achieve them, it would leave it in a much healthier position. While it’s painful, especially for the 50,000 people who are set to lose their jobs, it seems to be a necessary step for the global banking giant to take.

Similarly, RBS has not yet returned to full financial health following the credit crunch. Certainly, its management team is doing an excellent job of improving the quality of its asset base and also in making the bank leaner and offering the scope for fast-growing profitability in future years. Despite this, RBS still lags behind its peers in terms of profitability. And in 2016, it’s due to be well behind a number of its peers when it comes to dividend payments, with the bank set to pay out just 5% of profit as a dividend.

Appealing valuations

As a result of their challenging near-term outlooks, HSBC and RBS trade on highly appealing valuations. In the case of the former, it has a price-to-earnings (P/E) ratio of just 10.2 and this indicates that there’s tremendous upward rerating potential. Furthermore, HSBC yields a whopping 6.2% from a dividend that’s covered 1.6 times by profit and therefore appears to be highly sustainable.

Meanwhile, RBS trades on a P/E ratio of only 12 and, while it’s due to yield just 0.4% next year, a payout ratio at the same level as HSBC would equate to a yield of 4.7%. This indicates that there’s strong income potential over the medium-to-long term.

Looking ahead to 2016, both banks are due to report a fall in their bottom lines, with HSBC’s net profit expected to fall by 4% and RBS’s by 9%. While this result would be disappointing, the margins of safety on offer appear to indicate that this is already priced-in. Further risks from a slowing Asian economy (in the case of HSBC) and a failure to continue to recover from the global financial crisis (RBS) also appear to be reflected in the valuations of the two banks.

As a result of this, both HSBC and RBS appear to be strong long-term buys at the present time. While 2016 is likely to be a much better year than 2015, their full potential may not be realised until further down the line. That could be when their strategies begin to have a bigger impact on their financial performance and, in the case of RBS, the government sells its stake in full.

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Peter Stephens owns shares of HSBC Holdings and Royal Bank of Scotland Group. The Motley Fool UK has recommended HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.