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Two hidden banking stocks I’d buy with £2,000 today

If you want to add banking stocks to your investment portfolio, you’ll probably think of the big high street banks.

But they aren’t the only choice for UK investors. The recent performance of some smaller banks suggests to me that they could be superior investments.

Beating expectations

Underlying pre-tax profit rose by 21% to £167.7m in 2017 at buy-to-let mortgage specialist OneSavings Bank (LSE: OSB), beating market forecasts.

The group’s underlying earnings rose by 23% to 51.1p, ahead of consensus forecasts for 48.1p per share. This supported a 22% increase in the dividend, which rose to 12.8p per share.

Despite these solid figures, shares in the bank — which trades as Kent Reliance — fell slightly this morning.

This fall was caused by the bank’s warning of “a significant increase in operating costs in 2018”. However, I don’t think investors need to be too concerned. As I’ll explain, I believe this bank remains well-positioned for growth.

Challenges ahead

This sector does face some headwinds. Recent new rules for buy-to-let landlords have made the business tougher, and the market is shrinking. Banks also face additional regulatory costs, which OneSavings estimates at £7m in 2018.

Funding costs for new lending may also rise this year, as a government-backed cheap funding scheme has now closed. This could result in higher interest rates on savings accounts in 2018.

I’m still positive

OneSavings’ after-tax profits have risen from just £9.1m in 2012 to £126.9m in 2017. This growth process continued last year, when the bank’s loan book grew by 23% to £7.3bn.

So far, loan quality appears to remain high. The bank’s loss ratio on loans improved from 0.16% to 0.07% last year. Return on equity — an important measure of profitability — remained high at 28%, albeit down by 1% from 2016.

Trading at 390p, these shares look expensive compared to their net asset value, which I estimate at 238p per share. But the bank’s high return on equity means that the shares trade on just 8 times forecast earnings with a yield of 3.3%. I believe further gains are likely, despite the headwinds facing the business.

A better alternative?

OneSavings Bank isn’t the only specialist lender that’s performing well. One rival is Paragon Banking Group (LSE: PAG), which focuses on buy-to-let, commercial loans and motor finance.

Like OneSavings, Paragon gets much of its funding from the retail market, where it offers a competitive range of savings accounts. Funding from deposits doubled to £3.6bn last year, indicating good consumer demand for savings products, even at low interest rates.

What caught my eye was Paragon’s apparent combination of balance sheet strength and rapid growth. Total lending rose by 28% to £1,853.4m last year. This lifted earnings by 6.4% to 43.1p per share and boosted the group’s return on tangible equity to 13.4%.

Although the group’s return on equity is lower than that of OneSavings, Paragon’s CET1 ratio — an important measure of strength — is higher, at 15.9% versus 13.7%. Shareholders also receive a more generous level of income, as the policy from 2018 is to pay out 40% of earnings as dividends, compared to 25% at OneSavings.

Paragon shares currently trade on a forecast P/E of 10.6 and offer a prospective yield of 3.7%. If you’re interested in building a market-beating portfolio, I believe both of these stocks deserve a closer look.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.