The Motley Fool

Is It Time To Ditch Barclays PLC And Buy Challenger Banks Shawbrook Group PLC & Virgin Money Holdings (UK) PLC?

The UK banking scene is changing. While it was once dominated by just a handful of established names, it’s gradually transitioning towards a less concentrated industry where challenger banks such as Virgin Money (LSE: VM) and Shawbrook (LSE: SHAW) are gaining a foothold in the lucrative saving and lending marketplace.

In fact, those two banks are seeing their mortgage books rise at a rapid rate and with their earnings set to grow by 33% (Shawbrook) and 40% (Virgin Money) in the current year, they have a clear catalyst to cause investor sentiment to improve. Additionally, with both banks trading on relatively appealing valuations, they have clear capital gain potential – as evidenced by price-to-earnings-growth (PEG) ratios of just 0.3 apiece.

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Although they’re attractive investments, challenger banks have thus far had it all their own way. In other words, trading conditions have been highly favourable, with the UK economy recording excellent growth numbers in recent years and demand for credit being sky-high due to a loose monetary policy.

While such circumstances may last in the short-to-medium term, inevitably in the long run things will change. Interest rates will rise, the UK economy will experience a downturn and earnings growth may be more difficult to come by. In such a situation, the financial performance of challenger banks such as Shawbrook and Virgin Money could disappoint and their valuations could come under pressure.

Establishment appeal

In this scenario, a larger, better established bank with a more diverse income stream (both in terms of financial products and geographical exposure) could prove to be a better buy. In this regard, Barclays (LSE: BARC) has huge appeal since it’s a truly global bank with a range of investment and retail banking services. As such, Barclays may be better able to withstand difficult trading conditions than challenger banks such as Shawbrook and Virgin Money and with it having a P/E ratio of just 9, its shares may prove to be somewhat more defensive too.

Furthermore, Barclays could match its challenger peers when it comes to earnings growth. In 2016, its bottom line may be forecast to rise by just 6%, but in 2017 Barclays is expected to record an increase in net profit of 34%. This puts it on a PEG ratio of just 0.3 and indicates that it has superb capital gain prospects over the medium term.

In addition, Barclays is due to yield 2.7% this year from a dividend that has scope to rise at a rapid rate as a result of a modest payout ratio and the aforementioned upbeat earnings growth forecasts. With Shawbrook and Virgin Money yielding 1.5% and 1.7% respectively this year, Barclays seems to be a much more enticing income play for 2016. As such, and while Shawbrook and Virgin Money hold significant appeal, Barclays may still be the preferred option at the present time.

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Peter Stephens owns shares of Barclays. 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.