Shares in Barclays (LSE: BARC) have fallen 5% this week. And deservedly so: if you announce soaring bonuses for investment bankers while profits are falling, there’s always going to be trouble.
Some investors think the drop in price has left Barclays looking good value, and that this is a buying opportunity.
But I’m not one of them.
The bonus situation is bad enough – it shows an unhealthy lack of respect for shareholders – but at a more fundamental level, Barclays faces serious challenges on both sides of its business. They’ll be expensive and difficult to deal with – and I’m not prepared to gamble on the Barclays team being able to pull it off.
Why shareholders should be worried about big bonuses
Let’s start with the bonuses. There’s a lot of carping and manufactured outrage around bankers’ bonuses. You might be tempted to ignore it.
But in fact, this is something that shareholders should be annoyed about, because Barclays paid out three times more bonus money to staff than it paid dividend money to shareholders.
The picture is even worse at the investment banking division (that’s where the City and Wall Street bankers are based). Bonuses for investment bankers jumped 13% to £1.58bn last year, even although profits in this division fell 37% to £2.5bn.
Barclays argues that it can’t retain the best bankers unless it pays high bonuses. But if that’s true, then I fear that costs at the investment banking division will always be too high for shareholders to ever get a decent return on their investment. I’m not interested in owning shares in a company that ends up being run purely for the benefit of its staff, rather than its shareholders.
I also fear that the bank’s relatively new chief executive, Anthony Jenkins, is failing in his attempt to change the culture at Barclays – that’s the message I get from soaring bonuses.
Investment banking is a terrible business
So why buy Barclays? You might argue that we’ll eventually return to the boom conditions we saw in 2007 or in the late ‘90s. When that happens, Barclays and other big banks will make big profits.
But I disagree. You see, mergers and acquisitions (M&A) have traditionally made up a big part of investment banking revenues. But the M&A market is changing.
As John Authers pointed out in the FT on Monday, the number of mergers will probably never return to the heights we saw in the late ‘90s. Many industries are now dominated by a few large players, and competition authorities won’t permit further takeovers.
Things don’t look much more promising at Barclays’ FICC division (fixed income, currencies and commodities). This is now the heart of Barclays’ investment banking business.
Profit margins are under pressure. Returns have been hit by regulators’ insistence that investment banks carry more capital on their balance sheets.
If you’re not up to speed on returns on capital, think of it this way: if a bank has capital of £1bn and makes £100m in profit, the bank is generating a 10% return on capital employed.
But if regulators insist that the bank has £3bn of capital on its balance sheet, the return falls to 3.33%. (For more on returns on equity watch my video on the topic.)
Accountancy group McKinsey reckons that the average return on equity in investment banking currently is 8%, and could fall to 4% by 2019 if nothing changes. 8% is too low and 4% would be very poor.
High street banking doesn’t look much healthier
Between the bonus culture and the poor long-term outlook, I suspect that Barclays will always struggle to generate a decent return from its investment banking business. On the retail banking business, I’m a bit more positive, but I’m far from enthusiastic.
The good news is that Barclays has a decent UK customer base. But the high street banking business faces plenty of challenges: fresh scandals emerge on a regular basis, and more cost cutting is needed. That means shutting more bank branches, which is never popular with customers.
UK banking is also becoming more competitive. British banking has grown used to having very high barriers to entry, so the ‘big four’ banks have benefited from a semi-monopoly.
But we now have five main banks, plus ‘challenger’ banks such as Tesco and Virgin Money. And most importantly, TSB will almost certainly become a completely independent business later this year. This added competition will keep a lid on margins.
On top of that, politicians will likely continue to criticise banks and maybe even introduce further levies and fines. This is especially likely if Labour wins the next election.
What to buy instead
Granted, Barclays is on a low valuation. It’s trading at 0.8 times the bank’s tangible book value – that’s lower than most European banks. It’s also on a multiple of nine times last year’s earnings.
But it’s not cheap enough for me. Costs are too high and I’m not confident that Jenkins can push through the culture change needed to address that. And I’m not keen on banks at the best of times, because it’s so easy for them to hide unexploded bombs in their complicated balance sheets.
If you really feel the need to buy a UK bank, I’d opt for Lloyds (LSE: LLOY) on the basis that it has a nice UK high street business, unencumbered by overseas operations or an investment bank. I’d also consider TSB when it floats for the same reason.
But to be honest, I’d rather avoid the sector altogether. I recently wrote about some of the great opportunities on the Aim market. I also like the look of Japan and emerging markets. All three options carry their own risks – but I reckon that the risk/reward ratio is much more in my favour in all three areas.
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