Why I’m Avoiding Shares in HSBC Holdings plc & Royal Bank of Scotland Group plc

Shares in HSBC (LSE: HSBA) and RBS (LSE: RBS) have been hard bit by the recent sell-off in European bank shares. HSBC’s shares have fallen to near a seven-year low, whilst RBS is close to a three-year low. Both banks are now trading well below their book values.

So why am I not buying these shares? %Here are my 3 main reasons:

Weak earnings track record

Both of these banks have never really recovered fully from the depths of the 2007/8 financial crisis, and now they may have to face another potential downturn in the economy.

HSBC’s recently announced 2015 annual earnings were significantly worse than many analysts had expected, and confirmed the downward trend in earnings. Adjusted EPS fell for its second consecutive year, to $0.65, because of rising loan impairment losses and slowing growth in Asia. HSBC’s overall return on equity has been consistently below medium term targets over the past seven years, despite management having reduced its ROE target twice, from 15%-19% to 12%-15% in 2011, and again to 10%+ in 2015.

RBS is in worse shape, with the bank making huge losses year on year. Although it is making some progress with retail and commercial banking, losses from its investment bank continue to drag overall returns into negative territory. The bank is set to announce its full year earnings tomorrow, and city analysts expect adjusted EPS will fall to 0.24p.

Medium term headwinds

In the medium-term, HSBC will likely face more headwinds than tailwinds. Its renewed focus towards emerging markets, particularly Asia, makes sense in the long-term, but expanding its presence whilst markets are slowing there will no doubt hurt profitability in the short-term. What is more, HSBC’s restructuring plan and the implementation of “ring-fencing” laws in the UK will lead to higher costs over the next few years.

For RBS, the worsening outlook of the global economy would likely mean it would take longer to sell or run-down non-core assets and losses from these assets and investment banking would delay its return to profitability. In addition, legacy misconduct issues continue to haunt the bank, with PPI provisions staying stubbornly high.

Dividend uncertainty

With HSBC’s earnings trending downwards, investors are getting concerned about the safety of its dividends. Shares in HSBC currently yield 8.2%, which indicates investors are beginning to doubt its sustainability. For now, though, the dividend looks safe. But, looking further ahead, it could come under pressure if profitability does not recover soon enough. Dividend cover is around 1.3x, which leaves little room for error.

The bank’s dividend futures, which are exchange traded derivative contracts that allows investors to take positions on future dividend payments, have priced in a 9% and 20% cut in its dividend for 2016 and 2017, respectively. Although most analysts do not think HSBC will make a cut unless the bank faces a major financial crisis, futures traders believe there is a very real possibility of a dividend cut.

RBS has yet to return to dividend payments, and given the recent change in the outlook for the sector, I’m not expecting the bank to return to payouts any time soon.

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Jack Tang has no position in any shares mentioned. 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.