When looking at individual UK blue-chip stocks, I thinking its always worth considering whether the company has good prospects of delivering a higher return than the FTSE 100 itself. After all, you’ve always got the option of investing in a cheap index tracker fund.
With this in mind, I believe Royal Bank of Scotland (LSE: RBS) is a stock to avoid, but rate insurer Prudential (LSE: PRU), which released its half-year results today, as a ‘buy’. Here, I’ll explain why exactly I have a negative view on RBS and a positive view on Prudential.
It seems that just as RBS is getting back on its feet after 10 years of financial surgery, it’s set to be pummelled by a fresh wave of body blows. In its half-year results earlier this month, it advised that it’s now “very unlikely” to hits its 2020 targets of 50% cost:income ratio and 12% return on tangible equity. It said this is due to “current market conditions, continued economic and political uncertainty and the contraction of the yield curve.”
Since then, we’ve had government figures showing the UK economy contracted by 0.2% between April and June. This is the first quarterly contraction in seven years, and raises the spectre of the UK entering a recession — two successive quarters of negative growth — before Brexit’s even happened.
Banks are highly geared to the performance of the wider economy, and with RBS being domestically focused, a UK recession would hit it hard. Looking to the longer term, the UK is likely to be a lower-growth economy anyway. And with the FTSE 100 containing many geographically diversified businesses, with exposure to higher-growth markets around the world, I think RBS is poorly placed to deliver a higher long-term return than a simple FTSE 100 tracker.
Sure, a share price of 202p gives a low forward price-to-earnings (P/E) ratio of 7.4. But that’s what I’d expect for a highly cyclical business, with what I view as a tough near-term outlook and long-term prospects of only pedestrian growth.
Prudential’s P/E isn’t quite as low as RBS’s, but in single-digits at 9.3 is still cheap by historical standards. Moreover, I think its plan to de-merge part of its business will unlock value for shareholders in the near term, while in the longer term, its geographical positioning makes it well placed to smash the return of the FTSE 100.
Prudential intends to de-merge its M&GPrudential business and list it on the London Stock Exchange as a separate company (M&G plc) in the fourth quarter of this year. After the split, existing investors will own shares in both firms. I rate the stock a buy today, because I think the valuation implied by the current share price of 1,460p, will move closer — after the separation — to a sum-of-the-parts valuation of 2,000p.
John Foley, chief executive of M&G, which is carried in Prudential’s results today as a discontinued operation, reckons M&G’s in “great shape to use the freedom of de-merger … to grow this business at scale.”
Meanwhile, Prudential will have valuable American operations and a fast-growing franchise in Asia, where there’s a terrific long-term growth story for its life insurance and other financial products. Indeed, the group today reported a 14% rise in operating profit in both the US and Asia. As such, I see considerably more long-term growth potential in Prudential than RBS.
G A Chester has no position in any of the shares mentioned. The Motley Fool UK has recommended Prudential. 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.