Almost 10 years on from the financial crisis and the banking sector is still finding its feet.
Barclays (BARC) has been charged with fraud, RBS (RBS) has scrapped the sale of its Williams & Glyn branches, Co-op has failed to find a buyer and the Government has only just offloaded the last of its stake in Lloyds (LLOY).
UK banks have shelled out millions of pounds in compensation over recent years and been caught up in a plethora of scandals. Colin McLean, founder of SVM Asset Management, says it could be another decade before the industry has resolved all of its issues.
McLean says: “The lesson may be to avoid leveraged low-growth businesses, there may be better prospects in companies that have core strengths to protect margins. [In Europe] it may take another decade or two before the banking sector resolves its fundamental problems.’
But other experts say that some of the UK banks are now worth backing.
Rob James, banking analyst at Old Mutual Global Investors, said: “Over the last 10 years the rules in the sector have been changing; capital reserves have been increased and balance sheets have shrunk – it’s been a painful process.”
Banking Shares Are ‘Undervalued’
James works with Richard Buxton on the Silver Rated Old Mutual UK Alpha fund, which has some 13 % of its assets in the banking sector. He thinks shares in the sector are cheap considering the value they offer. The £2.3 billion fund, which has returned 23.5 % over the past year, has HSBC (HSBA), Lloyds and Barclays among its top holdings.
James adds: “Of all the banks I look at, Lloyds is one of the simplest. It is a very simple UK retail bank, with a large market share and the ability to pay out good dividends. There are not many places you can get a good yield that isn’t incredibly risky.”
Lloyds Bank, now a fully privately-owned bank, is certainly a favourite among investors who are looking at the financial sector. Morningstar analyst Derya Guzel said the bank’s shares look undervalued at their current levels.
He said the management had done a great job at turning the bank around, completing the restructuring of the business earlier than planned in 2014. Mr Guzel is positive about Lloyds’ recent acquisition of credit card company MBNA, which has boosted its market share in the credit card sector to more than 25%.
The bank also accounts for 2.6% of the Henderson High Income trust (HHI) portfolio where manager David Smith likes how keen the management of the bank are to return money to shareholders; the bank reinstated dividends in 2014 and announced a special dividend earlier this year.
Smith, whose investment trust has returned 18.3% over the past year, has been increasing his allocation to the banking sector over the past year. More than 17% of the portfolio is now invested in financial services companies.
Investment Banking ‘Dragging Down’ Retail Banks
While Lloyds is already paying dividends, over the medium-term he likes Barclays. He says: “It is a good quality business with a good market share, but its investment banking arm has been dragging on the share price.”
While Barclays has endured hefty PPI fines and was this month dragged charged by the Serious Fraud Office, Guzel said the business had made good progress in restructuring and in improving its risk profile.
James said: “The core of Barclays – its high street banks and Barclaycard – are great businesses and make good profits. The investment bank has been a cause of angst and shares are undervalued because of that, but we are happy to wait.”
Difficult Times Ahead for RBS
But not all UK banks are so appealing. The Government still owns almost three-quarters of troubled Royal Bank of Scotland. While funds such as Henderson High Income avoid the stock because it doesn’t pay a dividend, James is cautious around the bank, despite its strong capital reserves, because it is still awaiting the outcome of an investigation by the US Department of Justice.
He says: “The bank has done a fantastic job of tidying up and slimming down the business and bringing it back to being a relatively unexciting UK bank. But we are concerned as it goes into negotiations with the US regulator.”
Guzel added that the bank had had mediocre results and said the “worst is not over” as it is “still in the midst of heavy restructuring”.
Another area which the managers are wary of is the challenger banks. James is concerned about the fast growth of some of the specialist lenders such as Shawbrook (SHAW) and Aldermore (ALD) at a time when the financial regulator is keeping an eye on consumer credit growth and buy-to-let mortgages. Experts on the sector say there are opportunities, but investors need to be picky.
Smith said: “Low interest rates on deposits and higher rates on lending should mean banks are more profitable, but there are some concerns around what will happen to the UK economy particularly post-Brexit, and how that could affect the banking sector. We are focusing on companies with good lending and strong capital reserves.”
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