UK banks are cheap but not attractively-valued given the number of impending headwinds facing the sector, according to a number of star managers.
Neil Woodford, SVM UK Growth’s Margaret Lawson and Liontrust’s Stephen Bailey all warn against holding any of the larger incumbent banks due to a combination of precarious balance sheets, legacy issues and the current ultra-low interest rate environment.
The UK banking sector has had a torrid time post the financial crisis, with the FTSE 350 Banks index underperforming the FTSE 350 by 87.81 percentage points since the start of 2008 with a total loss of 46.85 per cent.
Performance of indices since 2008
Source: FE Analytics
A lack of trust since the crisis combined with a series of misconduct-related fines appears to have taken its toll on the sector, with many investors believing the firms to be opaque, unreliable and vulnerable to further regulatory penalisation.
Seeing as we’re in the midst of an unusually long economic cycle, which has led to toppy valuations across many equities, some deep value investors have been won over by banks’ cheap valuations.
At the end of last year, Investec’s Alastair Mundy said he was seeking solace within the UK banking sector in an otherwise challenging environment for value investors.
“My comfort blanket at the moment is Royal Bank of Scotland – it’s a very strange comfort blanket that no one would usually go anywhere near,” he said.
“Other people seem to have common comfort blankets, but the problem is when they disappoint, they’re all going to want to be throwing out that comfort blanket together and I’m not going to be buying that comfort blanket off of them.”
While many investors believe in the ‘mean reversion’ concept – that everything will eventually move towards their long-term averages – SVM UK Growth’s Lawson says banks face too many challenges to justify buying or holding them.
“Although financials look cheap relative to other cyclicals – they’re down about 36 per cent relatively – when you look at absolute values they’re not a bargain. It’s for the same reason that it has been over the past five years, they have too much debt,” she explained.
“They’re not able to write off the bad debt because they don’t have enough capital to do so.”
“Also institutions like the ECB have been artificially depressing the price of risk in markets and people are therefore worried about balance sheets. What actually is the true value of these businesses?”
The FE Alpha Manager says the non-performing loans in the sector haven’t been exposed to the market, which means that there hasn’t been any price discovery and the sector is therefore untrustworthy.
“The other get-out clause for banks would be to reprice the risk and there have been various attempts at this as credit quality has fallen and there’s been illiquidity in markets, but it’s never really been sustained,” she continued.
“Also, the people that hold a lot of this debt couldn’t sustain an increase in the cost of their debt either. What the government has been doing is making capital available to banks but it’s only so they can forebear on the debt that they have.”
“This is all coupled with interest rates not rising, so they’re not going to get the benefit of interest rate margins improving. There also hasn’t been a lot of M&A transactions and the difficulty the investment banks have is too many costs so they’re not making profits.”
Fellow FE Alpha Manager Stephen Bailey says that, while the best opportunities in dividend growth is within the financials sector, this doesn’t include any of the incumbent banks as he deems them to be unattractive and un-investable.
For instance, he points out that RBS has recently had to postpone its first dividend payment, Barclays has halved its dividends, Lloyds has paid a dividend but it was generated from capital as opposed to earnings and HSBC is paying an unfeasibly high dividend despite balance sheet strains.
Performance of stocks over 1yr
Source: FE Analytics
“The concept of being too big to fail doesn’t exist anymore. We have a global mandate now to minimise the systemic risk of the big banks and we think there are going to be further regulatory pressures on them to retain a high degree of earnings and increase their capital buffers – the result of that will perhaps be very disappointing to shareholders,” he said.
“The opportunities are with the smaller guys. There are two sides to this – to reduce the systemic risk of the big guys you have to shrink their operations. At the same time you have to grow the operations of the smaller guys who can break into that space and try to dilute the risks that incumbent banks still possess, particularly in the mortgage market. That’s a huge issue in the UK.”
In star manager Woodford’s latest blog entry, he agrees that large banks pose a problem, having sold HSBC – the only blue-chip bank to feature across the Woodford portfolios – during the second half of last year.
The only banking stock he does hold at the moment is Atom Bank, which is a challenger bank with no legacy assets – a feature that the manager says is particularly attractive compared to traditional banks.
“[Large banks] have been weak this year – indeed, they have been weak for almost the entire period since the global financial crisis commenced,” he said.
“Recently, this weakness has been attributed at least in part to the ultra-low interest rate environment that we are living in. Banks struggle to make money in this sort of environment.”
“Net interest margins (the difference between the rate at which they borrow and lend) are currently very slim and could narrow further if we head towards negative rates. Paradoxically, extraordinary monetary policy depresses bank margins and, in so doing, undermines the banks’ ability to recover from the crisis that erupted in the financial system nearly 10 years ago.”
With this in mind, many investment professionals are joining Woodford in holding small challenger firms without any legacy issues and a focus on keeping up-to-date with technology.
Both Lawson and Bailey hold Virgin Money in their portfolios, for instance. The bank has a market cap of £1.5bn and is therefore a constituent of the FTSE 250 index.
Since the bank floated onto the market at the end of 2014, it has provided a total return of 31.21 per cent, more than doubling the performance of the UK mid-cap index.
Performance of stock vs index since IPO
Source: FE Analytics
“The reason we have Virgin Bank is because they have a focus on what they’re doing and the markets they’re addressing. It will also benefit if net interest rate margins were to rise, which hasn’t come through yet, but this is a good long-term driver, combined with the fact it has good prospects and it doesn’t have legacy assets,” Lawson said.
“The established players are facing big structural challenges. The benefit for new challenger banks is they don’t have the legacy assets and they have focus – they have the expertise to navigate the new technology disruptors.”
“People rarely go to banks any more, they do most things on their phone. Who’s going to be the winner there? We don’t know yet. But I think large banks have long-term structural problems and they definitely aren’t a bargain.”
