Earlier this week the government quietly sold around 6% of RBS, the bank it bailed out in 2008.
This decision has been controversial. Several commentators pointed out that the current price means that the taxpayer will make a £1bn loss on the sale.
While few people argue that RBS should be kept in state hands for the long term, the decision to sell it at the current price has raised eyebrows, especially since it were much higher only a few months ago.
Indeed, there are mutterings that some hedge funds may have found out about the surprise sale beforehand and shorted the shares, further depressing the price.
But none of that matters to investors. The only thing that they should care about is whether the shares are worth buying at the current price.
We think RBS shares might be worth a gamble.
RBS has a chequered history
In the years leading up to the crisis, banks went wild. Huge amounts of money flowing around the system pushed up asset prices. Many institutions took bigger and bigger risks in the belief that house prices could never go down, and that risk could be eliminated by smart financial instruments.
Under its chief executive, Fred Goodwin, RBS expanded at a rate that was aggressive even compared to its competitors. In 2007, it bought part of Dutch bank ABN Amro and became the biggest bank in the world, with assets of £1.9trn.
This meant that RBS became massively overextended just as the flow of money was drying up. The government forced it to raise extra capital from the market, but this failed. The taxpayer was forced to step in at a cost of £45bn, and ended up with a 79% stake in the bank. Goodwin was removed as CEO in October 2008.
RBS goes on a diet
The good news is that over the past seven years, Goodwin’s successors have focused on unwinding his legacy.
As part of this, the bank slimmed down drastically. It has sold off over 600 UK branches, plus Coutts, its private bank. Other sales include its insurance business and German operations.
Overall assets are down by nearly half from their peak levels, and expected to fall further. Normally such actions would be a big negative. But in this case it should help RBS become a much more stable and focused institution.
It is also having an immediate effect on the bottom line. The bank unexpectedly made a profit last year, and recent results were also extremely positive.
The end of state control
At the moment, this isn’t benefitting shareholders much. The bank is banned from paying out dividends while it remains under state control.
So the good news from this week’s sale is that it shows George Osborne is eager to move RBS back to the private sector as soon as possible – a goal he will be eager to accomplish given his ambitions to succeed David Cameron as prime minister.
Importantly, studies have shown that investing in newly privatised companies can be a smart move. Around two-thirds of the companies that were sold off in the 1980s and 1990s outperformed the market.
While a few shares, such as BT and British Airways, haven’t done so well, others, including BAA and British Gas, proved lucrative. Indeed, one company, Amersham International (a medical device group sold off in 1982) produced huge returns for shareholders when it was bought by General Electric for £5.7bn in 2002.
It’s clear that professional managers answering to shareholders are far better at running a company than civil servants or government-appointed trustees.
Governments are also bad at selling assets. Since a failed privatisation leads to a lot of bad PR, they tend to be undervalued – as with the botched sale of Royal Mail in 2013. The state also has a knack of selling when the market is at its lowest point, as it did with gold between 1998 and 2002.
Litigation risk priced in
One of the big unknowns with RBS is the risk of litigation. The US government is still pursuing RBS over sub-prime mortgages and related issues. And the 14-year prison sentence imposed on the Citigroup trader at the centre of the Libor scandal this week shows that banks can expect no mercy on other issues.
However, these concerns seem overstated. Litigation is a problem for the entire sector, rather than RBS specifically. RBS is also looking to sell its stake in US subsidiary Citizens’ Financial Group, which should further reduce its legal exposure. It’s hard to see how even the most aggressive legal costs could exceed the $10bn that the bank has already set aside.
In any case, these risks are outweighed by the fact that it is valued at an attractive rate. RBS (LSE: RBS) currently trades at 12.8 times forward earnings, and at a discount of 30% to its reported net assets. Even when these assets are valued more conservatively, there is still a 10% discount.