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Are UK banks set to join the equity party?
UK banking stocks have been out of favour with investors for much of the past decade and the recent period is no exception.
Last year brought a fresh wave of challenges for the sector which sold off sharply in the aftermath of Brexit on concerns that the UK economy would experience a severe downturn and banks would suffer an associated spike in impairments (bad debt write offs).
Despite a recovery in share prices in response to the surprisingly strong economic out-turn to date, the sector still offers some interesting opportunities.
When assessing a bank’s valuation, I believe the key metric is price to book – or the relative value of the assets of the bank to its stock market value.
Accounting rules adopted by the banks to measure their assets are generally different from the rest of the market or industries principally because the assets of financial service firms tend to be financial instruments, which can be easily valued at the open market.
As a result, banks account for their assets at mark-to-market value, unlike other industries which use historical accounting measures.
Moving goal posts around regulatory capital requirements and a slew of fines for historic misdemeanours have been a persistent drag on banks’ valuation.
The positive or negative deviation of market value from book value will be dependent on how much investors trust the accounts of the banks and how much confidence they have in their future earnings streams.
I regard December 2015’s Financial Stability Report, produced by The Bank of England’s (BoE) Financial Policy Committee (FPC), as a watershed moment for the confidence of both the banks and the wider market.
Mark Carney, governor of the BoE, sought to deliver certainty on future capital requirements and confirmed that there would be no further increase in aggregate capital requirements for the sector.
The stock market was initially dismissive but the Prudential Regulation Authority (PRA), the banking regulator, backed its rhetoric with a series of actions, allowing those banks with the strongest capital positions to return the surplus in the form of special dividends and share buybacks.
From a valuation perspective, clarity on the future capital base knocked out a key unknown and provided a much clearer roadmap for each franchise.
The major banks in the portfolio I manage are at different stages towards reaching their capital endpoint, or the level at which the regulator is comfortable with the bank’s capital position.
Last year Lloyds Banking (LLOY) was allowed to pay a special dividend and complete the £1.9bn acquisition of credit card business MBNA – signaling to the market that it is in a position to return a reliable stream of earnings to shareholders.
Litigation no longer a drag
Litigation has also been a significant drag on the sector but I believe we are closer to the end than the beginning on the major impairments, PPI and Department of Justice fines which have consistently depressed existing and yet-to-be earned capital.
The majority of the fines relating to the misdemeanours occurring pre- and immediately post-crisis have largely been agreed or at least provisioned for.
I suspect that for a generation there will be a degree of litigation risk in the sector as banks are now seen as legitimate targets. The sector has implemented meaningful changes to the way they market and sell products, which ought to limit future liabilities of this nature.
In short, some limited uncertainty around capital persists, but the ‘black hole’ in core equity capital (the measure of a bank’s financial strength from the regulator’s point of view) which has dominated the narrative in recent years no longer stands.
With a more stable outlook on capital, I can now focus on earnings (and therefore the return on that better defined capital base) that each franchise can generate and ultimately, the appropriate multiple of book value at which I believe the shares ought to be valued.
In the context of both the macro backdrop and my discussions with management, I believe analysts’ current earnings forecasts are conservative.
My conclusion does not rely on a view around interest rates: clearly, if rates rise more quickly than the markets are currently anticipating, that would be very helpful for bank earnings. You do not need to rely on that, in my opinion, to think that the valuations are attractive here.
Looking ahead, I believe that UK banks simply need to continue to deliver on cost, continue their work to rationalise the non-core parts of their businesses and drive volume, in order to achieve modest growth.
In a normalised environment, even a modest level of growth generates an earnings stream which, to my mind, makes the sector look very attractive. Invesco Perpetual Select Trust UK Equity Share Portfolio (IVPU) has significant exposure to the UK banks sector.
James Goldstone, investment manager Invesco Perpetual
Where securities are mentioned in this article they do not necessarily represent a specific portfolio holding and do not constitute a recommendation to purchase, hold or sell.
Where James Goldstone has expressed opinions, they are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco Perpetual investment professionals.