Simon Edelsten, a fund manager at Goshawk Asset Management wrote a thought-provoking piece on investing in banks in this weekend’s FT Weekend edition. This blog post provides a summary of the article:
The historical P/E ratio of European equities is about 18x on average, compared to 26x for the S&P 500. Most of this difference is explained by the US being awash with tech companies with exciting stories trading at very high P/E ratios, whilst European markets have more “boring” financial stocks, which trade at much lower P/E ratios.
Most European banks trade at between 7x and 9x earnings. Taking a handful of banks P/E ratios as examples: Lloyds trades at x9, HSBC at x9, SocGen at x8.4, and Barclays x8.5. Looking at a Price/Book value, most banks tend to trade at Book Value, or at a discount. This compares with non-bank companies which tend to trade at significantly higher P/E and P/B ratios.
The key reason put forward by Edelsten as to why banks trade at low P/E’s is because their risk is much greater than non-banking companies.
Their primary role is to keep deposits safe, and lend money to house buyers and businesses.
Banks earnings (and share prices) have risen as interest rates have been on the up since 2022. In a rising interest rate environment, banks can get away with a bigger margin between what they pay in interest on deposits and what they charge on customer loans. (Rates on deposits are sticky whilst rates on loans are often variable rate interest, linked to the central bank base rate.
However, in a falling interest rate environment, the opposite tends to happen, where interest income shrinks as the interest rates charged on loans drops, and deposit rates drop too. In addition to low profit margins (difference between rate on loans and deposits), profitability falls when loans start to underperform. In recessions therefore, bank stocks tend to struggle, and often require refinancing, which in effect asks shareholders to return prior dividends received and maybe more, to shore up the balance sheet.
As a result, bank earnings tend to be far more volatile than non-bank stocks, and so valuation multiples tend to be lower.
Valuation
In valuing bank stocks, the starting number is generally book value, or shareholders funds. This is the amount of capital provided by shareholders in the form of equity, as well as cumulative retained profits/losses. Lloyds Bank currently has a share price of 64p per share, and a book value per share of 74p, therefore the price to book ratio is 0.86/1. You could argue it trades at a 14% discount, since banks tend to trade at a price/book value of 1.
Regulation
After the global financial crisis, regulators forced banks to hold much bigger reserves on their balance sheet, which means banks must have higher equity levels, and cannot lend out as much. Incidentally this has been one of the reasons that the private credit industry has ballooned in recent years.
Edelsten writes that relaxing these strict reserve requirements and allowing banks to lend more is becoming an increasingly attractive option for politicians to spur growth. Lower capital requirements would lead to increased loans being made, and higher profits, resulting in higher dividends, both which would be attractive for shareholders.
Edelsten offers five check-list factors for assessing banking stocks as an investment:
- Does the bank operate in an economy with steady or improving economic prospects?
- Does it have a high market share so it can lead on setting lending rates?
- Do its shares trade below book value and does its profitability have scope to rise?
- Is it run by steady individuals who avoid risks in lending and trading?
- Is there a financial crisis around the corner?
He posits that now might be the time to invest in bank stocks, given where we are in the economic cycle, and notes three stocks with interesting prospects:
- Lloyds Bank – dominant market share in mortgages which will recover given a drop in interest rates to spur mortgage activity. Their share price took a knock last year due to the car loan mis-selling issue, but its subsequent recovery suggests any redress may not be as bad as initially thought. (Close Brothers share price has recovered too during the past few weeks)
- BNP Paribas and Banco Santander – for exposure to the European market. A cease-fire in the Russia/Ukraine war might spur European growth (the market has seen positive momentum this year).
- HSBC – trades at a 20% discount to book value, with a 5.5% dividend yield, and has exposure to economic recovery in the UK, Europe and China. The new CEO Georges Elhedery has been tasked with restructuring the business. A split between the Hong Kong and European business could be on the cards.
He closes the article with a cautionary note: Take your pick. Just do not “buy and forget”. Owning bank shares is like picking up pound coins in front of a steamroller – fun until you are flattened.