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06 October 2023

Banking Comeback

This article was taken from the August issue of Market Insight. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.

When discussing investable sectors, banking is one which has consistently divided opinion post-Global Financial Crisis (GFC). Many have considered the sector un-investable on the back of significant regulatory reform, dwindling profitability, and the legacy cost issues of products such as Payment Protection Insurance (PPI). While not fully back in vogue, sentiment seemed to have been changing to the banking sector at the start of the year as the positive effects of higher interest rates began to feed through. Increasing costs of loans and little change on the return on deposits helped near-term profitability metrics trending higher along with the share prices. Cue the failure of Silicon Valley Bank and the takeover of Credit Suisse by rival UBS and the wind has seemingly been removed from the sails.
 
With confidence still seemingly limited, markets could be considered to be behind the curve in the pricing of a sector with improved resilience over time and potential profitability tailwinds going forward. If the GFC revealed anything, it is that banks failed to maintain sufficient capital buffers to absorb losses in their risk assets. Regulatory changes post- GFC, however, required banks to increase said capital buffers, improving resilience through time and the stability of the banking system. While stability did improve, profitability declined as interest rates moved lower and profit margins became squeezed. Valuations of the UK’s banking sector followed suit to the point where domestic names such as Lloyds and NatWest both trade on 0.6x book value at the time of writing, calculated as assets minus liability, an optically cheap valuation which is generally considered a signal of an undervalued company.
 
Optically cheap valuations should never be a sole reason for purchasing shares in a company; deciphering whether the company warrants the cheap valuation is required. Declining profitability metrics generally warrant a cheap valuation, while sustained improvements in profitability warrant higher movements. The real questions for the banking sector are: ‘Is profitability improving?’ and ‘Is it sustainable?’.
 
On the question of profitability, the answer is clearly a ‘yes,’ if recent results are anything to go by. NatWest, for example, recently reported strong first-half growth in total income, return on tangible equity (a key profitability metric) and net interest margin (net interest income/earning assets). The balance sheet also looked strong, with customer deposits significantly exceeding net loans.
 
While profitability, at least in the short-term, is improving, the sustainability of these metrics is the real question. A simple heuristic could lead us to the view that profitability metrics above the cost of equity should result in a company’s market value trading above its book value. So, with numbers now showing this, the fact that banks such as Lloyds and NatWest continue to trade below their book values raises eyebrows. An opinion piece from Fidelity’s UK equity desk highlighted this point, with NatWest’s management guiding for sustained return on equity in the 14-16% range, the author noted their expectations for the bank to trade closer to 1.5x book value, way above the 0.6x multiple it currently trades on. Clearly the market remains skeptical over the sustainability of current profitability levels going forward.
 
With profitability higher and valuations low, banking shares are being bought in droves. The biggest buyer is the banks themselves, with swathes of share buybacks being announced within the broader trend of de-equitisation in the UK market on the back of strong capital positions and cash generation. Sticking with NatWest, its recent earnings report announced an on-market buyback program of up to £500m for the second half of 2023. Virgin Money followed suit with announcements of £175m of anticipated buybacks at the end of year results. At the upper end, HSBC unveiled its second $2bn share buyback following the bumper $8.8bn of quarterly profits.
 
From a high level, the outlook is positive for banks, but concerns remain. In its recent financial stability report, the Bank of England highlighted the continued uncertainty of the global economic outlook and challenged risk environment. The report also noted the effects of higher interest rates on household and business borrowing risks, but retained the expectation of the UK corporate sector remaining resilient to higher interest rates and weak growth.
 
At a bank specific level, net interest margins, the measure of the net return on the bank’s earnings assets, have increased markedly over 2022, but pressure looks to be feeding through given the headwinds of mortgage and deposit repricing. Operating costs also look to be on the rise with the previous example of Lloyds and NatWest showing high single-digit increases in operating costs.
 
Nothing in financial markets is clear-cut and the key question remains whether we are being compensated for associated risks. With healthy and growing dividend yields in the region of 6-7% on offer for companies trading at less than their book value, banking is clearly offering attractions for some, while others are expected to remain unconvinced.
 
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.
Banking Comeback

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