Although big banks are trading at bargain prices, are they really such good value? Tim Bennett examines the books of the biggest banks in the UK and US to uncover the hidden dangers behind the numbers.
Banks have been stockmarket pariahs since the credit crunch. The first half of this year has been mediocre for them in share price terms: the likes of Barclays, RBS, HSBC and Lloyds are all trading near the bottom of their 52-week ranges, and the sector as a whole has underperformed the FTSE All-Share for 2011. The news last week that the government might push for the ring-fencing' of retail banking from other riskier activities added to the gloom (see www.moneyweek.com/tutorials for more). In the US, Bank of America, Citigroup and Goldman Sachs are down 20% so far this year, with only JP Morgan bucking the trend with a more modest drop of around 3.5%.
So is now the perfect time to buy? Andrew Bary in US financial paper Barron's reckons so. "Big banks" are trading "at bargain prices", he says. Just look at their price-to-book ratios, for example. In theory, if the market capitalisation of a company is lower than the book value of the net assets on the balance sheet, that means you have a chance to buy those assets for less than they are really worth. Bank of America and Citigroup sport ratios of around 0.5 and 0.65 respectively, while over here Lloyds is sitting on around 0.7 (using the current market capitalisation over net assets as of December 2010), Barclays on 0.5 and HSBC on 0.7. At these levels, says Bary, "investors are paying little or nothing for the franchises and earning power".
Before you rush in, there are a couple of queries. Can you trust the book? And are these low values supported by other ratios? In both cases, the answer is no.
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A book' is simply the accounting value of a bank's net assets that is, assets (largely amounts owed to the bank by other people) minus liabilities (amounts it owes such as your savings). Now, if you were to liquidate the bank and sell off its assets, clearly you'd be getting fire-sale prices, so the value of the book' isn't reliable from that point of view. But even if you're just using it as a guide, it's hard to say just how realistic it is.
The first problem, as UK bank analyst Jonathan Pierce notes in a memo quoted on FTAlphaville, is that "the tail risk in UK bank-credit portfolios remains a particular concern". In other words, we don't know how many of those loans (assets) are going to go bad. Already, more interest-only mortgages (to the tune of £110bn) exist today than in 2007, despite "lower rates and tighter new lending criteria". So if interest rates rise, arrears and defaults could rocket. Indeed, "we would not be surprised if the first reaction of investors is to sell UK bank stocks when the rate rises are announced", says analyst Arturo de Frias of Evolution.
But even if rates don't rise, the UK economic outlook is very uncertain consumer confidence is low, house prices remain under pressure outside London and employment data is at best subdued. Then there's the ongoing fear over sovereign default risk in Europe (see page 4 for the latest news). Although Greece alone is largely a problem for French and German banks, who have the greatest exposure, the prospect of "contagion spreading to other economies such as Portugal, Ireland and maybe Spain, Italy and Belgium" is a threat to many more lenders.
The best indicator of bank health
Instead, says Pierce, "the single most important determinant of value" for banks is their dividends. Regular healthy payouts to shareholders demonstrate management confidence in future earnings and cash flow. Sadly, right now it's not looking good for banks.
Bank of America yields around 0.4% and Citigroup 0.1%. Leader of the pack is JP Morgan with 2.4% hardly eye-popping. In the UK, Barclays offers a forward yield of around 2.4%, Lloyds 2.6% and HSBC a more reasonable 4%. But even at that level, the reward (with retail price inflation at 5.2%) for the risk of future capital losses is low. Throw in the threat of heavier regulation the latest ring-fencing proposals come with higher capital requirements that would be bad news for profits, for example and it's hard to see the bull case for the banks. Their chief executives might have taken an average 36% extra as pay this year, but given that revenues only rose on average by 3%, that says more about barmy pay structures than it does about future share-price performance.
How to profit
As you may have guessed, we don't much like the look of any single banking share just now. However, as regular contributor James Ferguson pointed out at the recent MoneyWeek conference, the gap between the share prices of Lloyds and RBS is now at a three-month high (see chart above). That suggests there may be an opportunity here, particularly as Lloyds seems to have recognised a larger proportion of bad debts than RBS.
To bet the gap will narrow, you could do a pairs trade, using a spread bet. You would buy (go long') Lloyds, and sell (short')RBS. You have to balance the trade up to have the same exposure on both legs (so that you are market neutral' see page 44). Say the Lloyds share price is 50p and RBS is 40p. You need to bet 5/4, or 1.25 times as much per point on RBS as Lloyds to give an equivalent sterling exposure long and short. So if you were betting £10 a point on Lloyds, you'd bet £12.50 on RBS. Ignoring bid-to-offer spreads, that way if Lloyds rises 5% to 52.5p and you are long at £10 per point (where 1 point is equal to a 1p movement in the share price) you make £25. If RBS also drops 5% to 38p you make £25 on that leg too (2 points x £12.50). Of course, if the bet goes against you, you'd lose the same amount. Always remember, with spread-betting you can lose more than your initial stake.
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Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.
He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.
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