UK banks still aren’t safe investments despite their appealing dividends and improvements in conduct, according to Franklin Templeton’s Colin Morton.
The manager of the Franklin UK Equity Income and Franklin UK Rising Dividends funds is particularly unnerved by Lloyds Banking Group, which resumed dividend payments in February this year after annual profits quadrupled to £1.8bn.
Performance of stock vs index in 2015
Source: FE Analytics
Despite this, Morton (pictured) believes there are traits that make the banking giant too high-risk to consider buying into. 
“When I look at Lloyds, a couple of things worry me specifically,” he said.
“Firstly, it is very heavily involved with the UK mortgage market. Bad debts at the moment are at all-time lows, they’ve almost never been as low as they are this year, so it’s a big concern that this is as good as it gets, if you like, with interest rates close to rising.”
The second factor worrying the fund manager is that the stock is making “far too much money”, which could mean the bank is picked up by regulators for overcharging customers at a time when UK interest rates are still at 0.5 per cent.
“A lot of [Lloyds’] finances themselves are next-to-nothing at the moment, but the mortgage rate that a lot of people have to pay is still 4 per cent plus. A lot of those people that are paying that rate can’t go anywhere else – they either haven’t got the ratios to go elsewhere, they’re still in some sort of negative equity or they’ve borrowed too much money for historic reasons,” he said.
“It concerns me a bit that those are the people that are seemingly not getting the best rate in the world at the moment, and it concerns me that it might be picked up on.”
The fund manager has started to take a closer look at banks, however, due to their attractive dividend yields.
He adds that, while he is bearish on Lloyds Banking Group, it does have some positive traits that other investors could find appealing.
For instance, the company’s share in the mortgage market is in excess of 30 per cent because it lends through four major UK banks – Lloyds Bank, Halifax, Bank of Scotland and Scottish Widows subsidiaries.
“This is because of what happened in the financial crisis – they had to rescue HBOS at the time, even though in the end it was a terrible year for them. But during the crisis, they came out the other end of it because they were in quite a strong position,” Morton explained.
On a general note, he adds that UK banks have cleaned up their act following a string of scandals over recent years including Libor fixing, the mis-selling of payment protection insurance, the introduction of non-complying interest rate hedging products and the manipulation of foreign exchange rates.
“Banks generally seem to be behaving a lot more sensibly than they were, as you would expect them to be. Plus there’s a lot more regulation making sure they have to behave more sensibly, so there are some positives and [banks are] something I’m looking at closer, but they generally aren’t something that excite me because of how difficult they are,” the manager explained.
Morton believes that banks are opaque institutions and as such it can be difficult to understand the drivers of the organisations and the ‘beneath-the-bonnet’ workings of them.
“It’s a lot better than it used to be – if you go back pre the crisis, banks were running a lot less equity and a lot more debt and liabilities. They’re nowhere near as risky as they were, but they’re still very risky positions,” he said.
While the manager doesn’t hold any banks in his UK Rising Dividends fund or in his allocated section within the Franklin UK Managers’ Focus fund, he does have a 3.6 per cent weighting in HSBC Holdings in Franklin UK Equity Income, which places the stock in the fund’s top 10 holdings.
Morton says the reason he holds this specific stock is because it has both a high dividend and a high level of dividend growth. Currently, HSBC Holdings has a five-year dividend growth of 7.94 per cent and a dividend yield of 5.67 per cent.
“The reason I’ve got HSBC in the income fund is that we have a certain amount of yield we’ve got to achieve. Obviously HSBC have got a very attractive dividend yield at the moment and it does look very safe,” he explained.
“The dividend also looks incredibly solid and it gives us that global play. I would describe [the decision to hold it] as owning it for portfolio reasons. It’s not one of my top ideas and sector-wise I’m underweight compared to the index, it’s the only bank I have in my portfolio.”
“The yield is quite attractive, it provides exposure to some of the world’s best economies and that’s really the reason I own it. It certainly isn’t something that I have put in my best ideas [portfolio].”
Franklin UK Equity Income has outperformed both its sector average and FTSE All Share benchmark over five and 10 years.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
It is deputy-managed by FE Alpha Manager duo Mark Hall and Ben Russon, and has achieved a top-quartile annualised volatility, alpha ratio, maximum drawdown and Sharpe ratio, which measures risk-adjusted performance, over Morton’s tenure.
The £170m fund has a clean ongoing charges figure (OCF) of 0.84 per cent and yields 3.73 per cent.
