Shares in focus: Does it make sense to buy banks?

It's often hard to say, but HSBC is well placed to prosper, says Phil Oakley.

Should you buy shares in a bank? I must admit that I usually find this a difficult question to answer. That's because I find it virtually impossible to work out what's really going on with their businesses. For some, that's enough of a reason to give the shares a wide berth.

A complicated business

Banking used to be simple. They took money from savers and lent money to borrowers. As long as the borrowers could afford to pay back their loans, and the interest received from them was comfortably more than the interest paid to savers, a bank would make money and be reasonably content with its lot.

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While this activity is still many banks' bread and butter, their businesses have become more complicated over the years.

Investment banking and trading the world's investment markets with fancy derivatives and lots of borrowed money allowed banks to make huge profits in the good times only to face ruin when things turned sour.

As investors in banks learned to their cost, they only found out about the big risks being taken when it was too late.

HSBC is one of the world's biggest banks. A few years ago it was one of the first to reveal that it had big problems caused by lending too much money to people who couldn't afford to pay it back the so-called sub-prime lending problem.

But unlike its British peers, such as Lloyds and Royal Bank of Scotland, it came through the financial crisis relatively well.

HSBC didn't have to go cap in hand to the government in order to survive, although it did have to ask its shareholders for £12.5bn of fresh money and cut its dividend to shore up its finances.

It also benefited from the fact that it wasn't heavily reliant on risky areas, such as the British housing market. Instead, it was getting a large chunk of its profits from emerging markets, where the economies were still growing strongly.

However, it's not all been plain sailing for HSBC. It's been embroiled in a money-laundering scandal in America and has been penalised for giving bad financial advice to customers. With its share price having recovered to its pre-crisis level (see chart), do the shares have further to run, or should you stay well clear?

How the shares have fared

HSBC seems to be doing well. Its underlying profits are up by 34% so far this year, mainly on the back of cost cutting. Yet some analysts are getting worried. Two-thirds of its profits come from Hong Kong and Asia (with the former accounting for over a third).

If economies such as China start to slow down or shrink, then there is a concern that HSBC could be left with lower profits and loans that cannot be repaid. Others point out that profits in Latin America have also fallen sharply.

Then there's the growing burden of regulation. Politicians and regulators want to make banks safer, so that taxpayers don't have to bail them out again. This means that they will have to set aside more money in the future so that they can cope with some of their loans turning bad.

Having more equity to make them safer means returns to shareholders can't be juiced up as much with borrowed money and will be lower than they were in the past.

This could make banks less attractive to investors. However, I think that there's some grounds for optimism with HSBC's business.

There's still plenty of fat to be cut from its costs, and the world economy is still expected to keep on growing, albeit at a modest 2% or so for the next couple of years. This should help HSBC to keep growing its profits. The consensus among City analysts is that it can expect earnings to grow by 9% next year.

Are the shares good value?

The shares currently trade on 1.2 times book value (its net asset value) and are making returns on shareholders' money of just over 10%. That doesn't look screamingly cheap and is very similar to the valuation and returns of Lloyds Banking Group.

Yet, I'd rather own HSBC shares over Lloyds most days of the week. Lloyds remains a risky punt that is being driven by a heavily manipulated UK housing market. It is also still reliant on more than £150bn of risky wholesale funding, as opposed to savers' deposits.

To me, HSBC is a much safer bet. Its loans are comfortably funded by deposits (80% loan to deposit ratio), while it looks to have enough money to keep the regulators happy.

A recovering US housing market may also give it a chance to slim down its mortgage business there, which would be a good thing to do.

Yes, there are risks, given its reliance on Asia, but if you want to own banking shares then you'll sleep more easily with HSBC's finances than you will with Lloyds' or RBS'.

Then there is its juicy dividend. At the moment the shares yield 4.6% based on this year's forecast dividend. Analysts expect dividends to grow by 10% per year over the next couple of years. If HSBC can deliver this, then I reckon the shares could be a reasonable investment just now.

Should you buy now?

Banks are risky investments and are not for everyone. But if you accept this and are looking for a decent and growing income stream, buying HSBC shares might be more rewarding than having an HSBC savings account.

Verdict: buy

HSBC (LSE: HSBA)Share price: 698pMarket cap: £130.9bnNet assets (Sep 2013): $179bnPrice-to-book-value ratio: 1.17 timesP/e (prospective): 11.9 timesYield (prospective): 4.6%Dividend cover: 1.8 times

What the analysts sayBuy: 20Hold: 14Sell: 3Target price: 776p

Directors' shareholdings

S Gulliver (CEO): 4,865,913I Mackay (CFO): 673,286D Flint (chair): 441,511