Banking on British Banks?

01/14/2009 10:51 am EST


Peter Shearlock

Editor, Growth Company Investor

Peter Shearlock, columnist for The IRS Report, is testing the financial waters with two UK bank stocks.

After falling by up to 90%, bank share prices have started recovering. Most have recapitalized their balance sheets, raising a combined £68 billion of new capital. The government has made it plain none of the big names will be allowed to fail.

For value investors like myself, many of the normal rules do not apply. Banks live on high gearing (heavy debt compared to its balance sheet—Editor), which one would normally avoid. Asset backing is of limited relevance in normal times and banks are, almost by definition, highly cyclical stocks.

But after dramatic falls, there is at least a case for bottom-fishing. Four of the six UK banks are selling at a marked discount to tangible book value, with capital bases for most expanded to levels not seen for decades. And they have already swallowed big losses on the “toxic assets” from repackaged American mortgages.

City analysts remain bearish, but then few were shouting “Sell” at the top of the market, either. Timing is obviously an issue. Bank balance sheets are likely to shrink over the next couple of years—despite woolly guarantees to sustain UK lending at 2007 levels. There is also likely to be a shift towards more liquid investments, such as government bonds, in order to retain the confidence of overseas banks and investors who are currently funding much of the £740-billion gap between what banks have loaned out and what they have taken in UK deposits.

The recession bites will bring losses on mortgage and business lending. All of this is going to hit margins. Earnings per share estimates could look overoptimistic in a year.

So where does that leave individual banks? Royal Bank (NYSE: RBS) is interesting. A price tag of just £21.5 billion for a business that combines Royal Bank of Scotland, NatWest and much of the Dutch bank ABN Amro offers long-term up side.

The shares are selling for not much more than half estimated tangible book value. But we don’t yet know what direction the new chief executive will take, after a recent strategic review. Certainly, the bank is going to get smaller. For the long view, RBS has speculative appeal. (It closed at $14.93 Tuesday—Editor.)

So, too, does Barclays (NYSE: BCS). With its investment bank and top-notch investment management business likely to contribute more than 40% of next year’s profits, Barclays looks good value at a discount to net worth. In acquiring much of Lehman Brothers for next to nothing, Barclays has the potential to sidestep the shrinkage in the rest of the sector. (It closed at $14.93 Tuesday—Editor.)

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