Safe distance

12 July 2010 | By Abigail Montrose

Eighteen months ago the British banking sector was in crisis. Awash with bad debts, credit markets had dried up and only government intervention saved the banking system from collapse. An improvement in the global economy, greater liquidity in the markets and a return to profitability has meant that British banks operate in a different environment. But fresh challenges threaten their recovery.

The European sovereign debt crisis is a major concern, as are economic and regulatory uncertainties. While tighter regulation is not a bad thing, there is concern that if it is too onerous it could discourage the banks from lending and stall the country’s recovery.

The so-called domestic British banks have been hardest hit by these worries while those with exposure to Asia, such as Standard Chartered and HSBC, have fared better. These banks are relatively well positioned given the subdued outlook for the British economy and worries about a potential double dip, says Tim Gibbens, a global financials analyst at Alliance Trust.

“These banks are trading on higher multiples than the domestics and are exposed to the higher growth markets so they still appear relatively attractive long-term investments,” he says.

”These banks are trading on higher multiples than the domestics and are exposed to the higher growth markets”

Bruce Packard, a research analyst at Seymour Pierce, points out that HSBC has achieved a 13% CAGR (compound annual growth rate) in its customer deposits since 1995. He argues this growth rate is sustainable as HSBC has access to several billion savers in the developing world. An added attraction is that the bank is also relatively straightforward to value.

“The bulk of the bank’s value resides in the future revenue stream generated by customer deposit funding. We can see this in the HSBC share price stability, compared to the wild variation in high/low prices at Lloyds, RBS and Barclays,” he says.

HSBC also benefits from a stronger balance sheet than other British banks with a better loans to deposits ratio and a much bigger franchise with opportunities in Asia, says Nick Brind, an income fund manager at HIM Capital.

“We think the next three to five years will be tough and not an environment where you will want to take ­significant risks. Financial institutions with stronger balance sheets can take advantage of spending and acquisition opportunities. We’ve seen that in previous crises: the strong get stronger,” he says. (article continues below)

But others argue that British domestic bank shares offer better value. Ian Gordon, a banking analyst at Exane BNP Paribas, has just downgraded Standard Chartered from an outperform to neutral. While Standard Chartered remains cheap in absolute terms, and highly attractive over the longer term, he says there is better value elsewhere.

“Following Standard Chartered’s sustained relative outperformance against our European banks universe, we advise investors to concentrate overweight positions in Barclays, Lloyds Banking Group and the French banks to take maximum advantage of distressed entry levels for those names.

“It is the re-emergence of distressed pricing within the UK and European bank sectors which drives our relative downgrade of Standard Chartered. All UK domestic banks once again trade at a discount to 2009 tangible book values,” he says.

As well as being cheap the domestic banks are also raising capital and improving their funding positions, although they still have some way to go because wholesale funding is fragile and funding outside the bond market largely closed now, says Gordon.

“We’re seeing an improving picture. If you go back 15 months you had banks trading at less than half book value, pricing in the risk of insolvency. That is no longer the issue. Now it’s about how long and how fragile the return to profitability is. I think the market is slightly overpricing some of the risks and there is a great deal of opportunity within the sector,” he says.

Chris Kinder, a UK equities assistant fund manager at Threadneedle, agrees and is looking closely at Barclays and Lloyds. “I believe the return on equity will be above book value and in some cases it is already or will be in a couple of years,” he says.

”The market is slightly overpricing some of the risks and there is a great deal of opportunity within the sector”

Unlike Lloyds and RBS, Barclays did not go cap in hand to the government for financial support. Much of its profits come from Barclays Capital, which although a more complicated business with regulatory risks in America as well as Britain, is still trading below book value and offers potentially high rewards, says Kinder.

But others are less certain. Guy de Blonay, the co-manager of Jupiter’s Financial Opportunities fund, has held Barclays for some time, regarding it as a valuable holding with growth prospects. However, in May he “substantially” reduced his holding, which had accounted for 6.8% of his fund.

As his fund has a global mandate, Blonay has been able to move away from the eurozone and British banks over the past couple of months to economies where he thinks there are better credit growth and employment prospects.

“Domestic UK banks do offer value but we think there is better value elsewhere at the moment. That’s taking into account the macro as well as the stock itself. Cheap stock is not enough, it needs to be operating in a favourable economic environment. The UK is on the mend but it needs more time to show its strength,” he says.

Lloyds Banking Group is also attracting interest. Both Exane BNP Paribas and Nomura have it as a buy, with the bank expected to post profits this year and BNP tipping it to ultimately achieve a full recovery.

Packard points out that if Lloyds has a sustainable funding model then the shares are probably cheap. But he says it is difficult for the management to know what is a sustainable loans to deposit ratio.

“They agree it’s not 1.7 times but how does Lloyds get down to 1.4 times or even one times and what does that do to their revenue? They’ve large margins at the moment so they appear profitable but interest rates are at a 40-year low,” he says.

RBS is generally regarded as the least attractive of the British banks. The bank is to divest itself of 300 branches, and its insurance businesses, which include Churchill, Direct Line and Green Flag, are to be sold. The bank also has a complicated business mix and is not as easy to understand as other British domestic banks.

But even RBS is attracting support at its current trading levels. At the end of May, Nigel Greenwood, a Standard & Poor’s credit analyst, raised his rating on RBS’s and Lloyds’ core UK bank subsidiaries.

 

Credit Suisse’s banking analysts, Jonathan Pierce and Robert Self, also raised RBS, Lloyds and Barclays to outperform. They point out that all three are trading below their tangible net asset values (TNAV) and that their reliance on short-term funding has been going down.

“We don’t see TNAV as a floor for share prices but we are comfortable on the ability of the balance sheet to withstand further dislocation in markets and impairment charges,” they say.

While many are still cautious of British bank shares, the subordinated debt of financials - that is, the debt or corporate bonds they issue - is an attractive proposition, says Brind.

”With all the new regulations, that is, more capital, minimum liquidity rate and so on, the debt of the banks is more attractive and safer”

“With all the new regulations that are coming down the pipeline - more capital, minimum liquidity rate and so on - that makes the debt of the banks look much more attractive and safer. On a number of these the spreads, as in the yield over gilts, are still quite wide and therefore attractive on a stand-alone basis,” he says.

Among other financial stocks the insurance sector has been attracting attention. The life insurance sector is often given a wide berth by fund managers because it is so competitive and the businesses are complex and hard to understand and value. But recent merger and acquisition activity, changes in business models and moves by companies to make their businesses more transparent are changing this. With many shares trading at historical lows, the sector is attracting interest.

Prudential’s protracted bid for AIG’s Asian unit, AIA, may have ended in failure, but Prudential is still an attractive proposition, says Gibbens.

De Blonay also regards the stock as attractive and it is the only British insurer he holds in his fund. But others are more cautious, questioning the company’s strategy and management in the light of its failed bid for AIA.

Clive Beagles, who manages the UK Equity Income fund of JO Hambro Capital Management, says there is better value elsewhere. He says that the creation of Resolution by Clive Cowdery has shaken up the sector. Resolution has been buying up parts of the life industry and changing business models, forcing other life insurers to reassess what they do.

 

“For most of the past 20 years life company managements have done no more that try to grow their sales lines and their market share and hope that they might make a profit in 20 years’ time. There’s been a material change in attitude, partly driven by management and partly by these external influences,” he says.

Legal & General is where the most radical change has taken place, according to Beagles. He no longer sees the company’s reports and accounts as opaque, and this improved clarity, along with the emphasis on collecting cash from policies already written rather than on writing new business, is a major change in the sector, he says.

While Legal & General may be at the vanguard of this change, Standard Life and Aviva are also going down this path, making them also an interesting proposition, says Beagles.

”We are seeing some consolidation in the hedge fund market”

“The stocks are being valued on laughably low valuations, huge discounts to embedded values, very high pre-cash per yield and very high dividend yields,” he says.
Jonathan Newman, a financials analyst at Brewin Dolphin, also likes Aviva because of the management’s shift away from growth to value and cash generation. He sees this in the company’s sale of Delta Lloyd, its Australian business.

“If they run the business for cash rather than for growth they will be able to generate value for shareholders,” he says.

The non-life sector has by comparison been attracting less excitement. The two big names in the FTSE 100 are Admiral and RSA. Newman regards Admiral as having an attractive business model, seeing it as more nimble and astute in what it does because it is a younger business and continues to produce results, whereas RSA is a more mature company but has little to distinguish it from its competitors he says, although it does pay good dividends, which appeal to some investors.

Despite this, Newman does not see much of a value argument in the non-life sector.

“There is not the same accumulation of value over decades which can potentially be unlocked as you might have at somewhere like Aviva. With RSA and Admiral what you see is what you get and they tend to trade not far off book value,” he says.

 

Others are more enthusiastic. Beagles points out that these stocks behave like utilities, doing well when everyone is worried about the economy as they are now, and less well when the market is more optimistic.

Brind also likes selective non-life firms, pointing out that many have strong balance sheets and are trading cheaply. He particularly likes Amlin and Lancashire Insurance. His other favourites in the financials sector include International Personal Finance, which is part of the door-to-door lender Provident Financial, and financial services group Hargreaves Lansdown, which he says will continue to grow.

Among general financials, of which only four are FTSE 100 names, Newman likes ICAP, whose share price has recovered, and Man Group, which is buying GLG, a fellow hedge fund manager.

“We are seeing some consolidation in the hedge fund market and Man Group is doing it to diversify its product range and to have more products to put through its marketing network. That’s been well received by the marketplace,” says Newman.

”At the moment Close Brothers is growing its loan book by more than 10% a year”

Beagles also likes selective financial services firms and is overweight in these in his UK Equity Income fund. He particularly likes Close Brothers, whose biggest business is its bank, which has a loan book of nearly £3 billion.

“It really is exploiting the opportunities to grow market share because of all the problems the other banks are experiencing and who have effectively withdrawn from their marketplace because they can’t afford to lend. Over the past 20 years Close Brothers has grown its loan book by 2-3% a year. But at the moment it is growing it by more than 10% a year and it is doing it at higher margins than it has ever written business before,” he says.

Real estate is the least popular of all the investment sectors, according to Merrill Lynch’s monthly fund managers survey. Despite the recovery and re-rating of commercial property prices at the end of 2009, many fund managers do not expect to see much rental growth over the next five years and do not like the fact that the sector is correlated to the banking sector.

But Beagles is more upbeat and points out that tenant demand in London in terms of valuations has improved sharply from its lows, although it is still well down on its peak.

“This is a sector where the valuations are demanding, the quoted companies have sorted out their balance sheets by having rights issues last year and where life is improving and quite frankly, no-one owns it. It’s a nice combination of characteristics as far as we’re concerned,” he says.

While economic, political and regulatory concerns weigh heavily on the financials sector there are still some bright spots and fund managers are managing to find value during these challenging times.