While the decision by banks like the Royal Bank of Scotland (RBS) and HBOS to raise capital via rights issues has generally been met positively, some managers are voicing doubts about the sustainability of banks’ earnings going forwards.
There are also concerns about whether banks can maintain dividend levels if earnings slow due to the economic downturn and consumer entrenchment. Some banks have already warned that dividends will depend on future earnings growth, while others have said they will not pay dividends in cash but through scrip dividends.
For UK equity income fund managers who often rely on bank dividends for income this could present problems.
(Source: Financial Express Analytics, total return, bid-bid over 3 years, IMA UT & OEIC universe)
Scrip dividends cannot be distributed to unit trust holders as income because they are essentially shares. This means investors could see income from their equity income investments fall if the fund they invest in holds banks issuing scrip dividends. Equally, banks which face uncertain future earnings growth could be forced to cut dividends, again to the detriment of investors.
Jan Luthman, who co-runs the CF Walker Crips Equity Income fund with Stephen Bailey, says: “Unit holders in funds that hold UK banks could see yields falling. As a result, UK centric banks seem an inappropriate holding for equity income funds for the time being.”
Luthman says he has turned away from banks with core businesses in Britain and instead holds ones that have greater business exposure to the Far East like Standard Chartered and HSBC.
In the UK, he says, banks face an uphill struggle with the consumer credit market tightening, increased loan deferments and defaults, rising unemployment and slowing economic growth. But banks with business in Asian countries like China should benefit from the continued rise of a new middle class plus a relatively untapped credit market, he says.
“There is a whole array of negative factors in the UK domestic economy that suggest banks are going to find it very difficult to grow earnings going forwards,” he says.
Optimists, however, argue that certain UK bank valuations look attractive now that their recovery trajectories appear to be in place.
Bill Mott, manager of the PSigma Income fund, which was launched for him last April after several years’ absence from direct fund management, says plans announced by some banks to raise additional capital should leave them well placed for recovery. Mott holds HSBC, his fund’s largest holding, as well as RBS and Barclays. Overall he is slightly overweight in the sector.
Leigh Harrison, who previously worked alongside Mott at Credit Suisse and who now manages the Threadneedle UK Equity Income fund, also believes there are opportunities among UK bank stocks. However, like Luthman, he is currently concentrating on companies that have exposure to the Far East.
“We do think that there are opportunities in the UK banking sector and we are focusing on well capitalised companies with low exposure to sub-prime lending and or significant Asian earnings, such as Lloyds TSB, Standard Chartered and HSBC,” he says.
2 June 2008