The recent sell-off in bank stocks presents an attractive opportunity for contrarian investors to gain exposure to an under-appreciated sector. Despite the recent market turbulence, the financial sector’s profitability should continue to trend upwards over the medium term. UK banks are also more resilient than they were during the last financial crisis, as they carry significantly more capital and have reduced their appetite for riskier assets.
It’s not all rosy though, and warnings signs are popping up. The UK economy, although resilient relative to other advanced economies, is beginning to slow a little. Forecasts still point to more than 2.0% real GDP growth for 2016 and 2017, but recent poor exports and manufacturing data indicate that there are significant downside risks to growth. In addition, there are concerns over slowing property markets, persistent misconduct costs and continued weakness in emerging markets.
Barclays’ (LSE: BARC) price-to-book ratio (P/B) is currently just 0.47, which indicates huge potential upside if the bank continues to improve profitability. Management has so far made steady progress with cutting costs, and it expects to achieve its core return on equity (ROE) target of 11% for this year.
City analysts are bullish, with 15 out of 22 recommending the bank’s stock as a strong buy. Adjusted earnings per share (EPS) is forecast to grow 24% to 21.5p per share in 2015, indicating an estimated P/E of just 7.4.
Should the bank continue to make substantial progress at running down non-core assets and reach its ROE target, I could easily see the bank trading at least 1.0x book value, and this would imply a potential upside of at least 110%. However, the bank has disappointed the market before, and would-be investors should expect a bumpy ride before the bank’s financial performance returns to “normal” levels.
Based on its P/B ratio, Standard Chartered (LSE: STAN) is the cheapest of the three, with its shares currently trading at just 0.37x book value. Unfortunately, though. this is reflective of market expectations that the bank will be far less profitable than many of its peers.
The bank has a long way to go in de-risking its balance sheet, by reducing industry and country-specific risks, as well as boosting overall profitability. Analysts expect the bank’s earnings to continue to trend downwards in the medium term, with a decline in adjusted EPS of 61% pencilled in for 2015.
Management is not particularly optimistic either, with a target return on equity of just 8% by 2018. That’s a three-year long wait for a recovery in profitability to a level that still falls well below its estimated cost of equity.
OneSavings Bank (LSE: OSB) is due to announce its full year results in March, but we can take a look at analysts’ expectations as a guide to its expected profitability. Net revenue is expected to climb 31% to £164 million, whilst underlying pre-tax profit is set to increase 51% to £105 million.
Although the challenger bank has a P/B ratio of 2.46x, its 30%+ return on equity means the bank is not especially expensive from an earnings perspective. Its 2015 estimated P/E is just 8.2, despite the bank’s outstanding track record of consistently delivering double-digit earnings growth. Looking ahead, underlying EPS is forecast to grow another 11% in 2016, which implies its shares trade at a forward P/E of just 7.4.
OneSavings Bank is my favourite of the three because, being a bank founded in 2011, it has no legacy misconduct liabilities. Provisions for customer remediation and other conduct related issues have cost UK banks more than £40 billion since 2011 — equivalent to almost two-fifths of the sector’s cumulative profits over the period — and there is no end in sight to further provisions being made by the big banks.
Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Barclays. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.