Why you can’t bank on bank shares

{"text":[[{"start":4.56,"text":"Investors have finally started to realise there’s more to equity markets than technology shares. And, as one dominant investment trend comes to an end, the next wave often starts in forgotten sectors."}],[{"start":16.675,"text":"One of these might be financials. Nearly 20 years on from the global financial crisis, banks are still looking relatively cheap. They’re kicking out attractive dividends (and buying back shares)."}],[{"start":28.551,"text":"These are resilient businesses. Some have survived centuries. Lloyds Bank, for instance, was founded in 1765; Barclays traces its origins back even further, to 1690. By comparison, most big tech companies have barely endured any testing: Nvidia was founded in 1993, Amazon in 1994 and Google (now Alphabet) in 1998."}],[{"start":53.04,"text":"Remember boo.com and pets.com? Or Pixelon, the video-streaming company that launched with a party featuring a reunion of The Who? It went bust less than a year later. Given how many of their contemporaries have bombed, the tech bros would probably prefer not to talk about “My Generation”."}],[{"start":69.6,"text":"If another tech storm is building, do financials offer a safer harbour? Hmmm."}],[{"start":73.2,"text":"For a short while I held a very junior management job in a large bank. Once a year I joined the budget-setting meeting. First, we would look at costs (large!): premises in the City, computers, people, trading capital. Then revenues: highly unpredictable. The problem was not just guessing how much business you would do with clients but the fact that revenues varied with equity and bond market levels and interest rates — and these were anyone’s guess."}],[{"start":100.284,"text":"It’s unwise, then, to value bank shares using standard price/earnings ratios. Their earnings are much less predictable than most companies’."}],[{"start":108.4,"text":"Professor Russell Napier (my old chair at the Mid Wynd Investment Trust) put it well when he said: “Bank profits are the fine sliver of hope between their assets and liabilities.”"}],[{"start":117.68,"text":"Shareholders in the collapsed Northern Rock may recall what happens when that sliver of hope disappears. Banking crises seem to turn up maybe once every 25 years, which is within most serious investors’ time horizons."}],[{"start":130.496,"text":"In light of all this, standard accounting definitions, developed for manufacturing businesses and most financial companies, don’t fit banks. When a bank talks about its “assets” it’s usually referring to its loan book. Its profit will contain both cash items, like fees, and non-cash items, such as the year-end value of investments held. After that year ends, these may go up or down."}],[{"start":154.56,"text":"With all this uncertainty, I tend to value banks by looking at their share price compared with their book value — a stable number found in the balance sheet (equity less goodwill). This acts as a base level for what a bank should be worth over the longer term if sensibly managed. I then look at how the profits compare with that book value: return on equity."}],[{"start":null,"text":"

"}],[{"start":174.441,"text":"Over the long term, most banks in most markets typically make about 10 per cent — and their shares trade slightly above book value. If a bank makes a much higher return than this, either it is in a market with little competition (some emerging markets) or it may be taking more risk — perhaps lending to companies prepared to pay higher rates but more likely to fail."}],[{"start":194.8,"text":"But there’s one other issue to take into account: meddling."}],[{"start":200,"text":"The chancellor’s decision this week to double the bank surcharge from 3 per cent to 6 per cent for 15 months — dubbed by some a “windfall tax” — highlights the fact that governments and regulators just can’t stop mucking about with them. It makes long-term investing difficult."}],[{"start":214.441,"text":"The main UK banks currently make returns on equity of around 9 to 14 per cent. Would we call that a windfall?"}],[{"start":221.115,"text":"The chancellor was clearly short of pools in which to fish. Taxing banks can slow growth because they have to make a higher return on lending to cover the tax drag and just widen the difference between interest paid on deposits and that charged on loans."}],[{"start":235.509,"text":"Tech start-ups tend to need short-term credit primarily, which banks aren’t used to providing. It’s the building industry and those dependent on mortgage availability that are hit most — two areas that didn’t need any more challenges. So a time-limited tax is at least to be welcomed."}],[{"start":251.362,"text":"Of course, “financials” doesn’t just mean banks. One sector that seems to have been making out like bandits is life assurance. But valuing them is complex. Most of their “earnings” come not from inflated premiums and limp annuity payouts but from market movements in their vast balance sheets. The risks are significant — such as changes in bond yields and mortality rates."}],[{"start":273.36,"text":"The life insurers tell us they’re very much enjoying the recovery from the brief Liz Truss moment. The collapse in UK gilts at that time led larger companies to inject a very large amount of capital into matching pension assets and liabilities. Since then, those liabilities (private sector pensions) have risen only modestly, while the yields available on the bulk of their investments (UK gilts) have shot up. Higher interest rates are bad news for most people but tend to be good news for banks (through higher mortgage rates) and pension providers."}],[{"start":304.72,"text":"These happy trading conditions allow Legal & General to pay out a very handsome dividend (more than 7 per cent) while also buying back shares. The accounts reveal that the dividend is not covered by earnings, but core debt has been falling, underlining how “earnings” in financial companies can be misleading."}],[{"start":322.57,"text":"I confess that I find investing in developed-market financials too unpredictable. I invest in banks in emerging markets, where governments look after their financial institutions because they are a key component of economic growth. These banks can be a simple way to capture an emerging economy’s growing prosperity."}],[{"start":339.28,"text":"We own ICBC, the largest bank in China, which trades at half its book value with a 5 per cent yield. Its 8.7 per cent return on equity should rise as China’s property woes gradually reduce."}],[{"start":352.72,"text":"With all investments these days, we have to think about the impact of AI. In financial services it should allow risk management systems to become more efficient and reduce administration costs — many banks are already reducing headcount."}],[{"start":364.557,"text":"But it’s a threat as well as a benefit. Newer online-only banks, such as Revolut, can charge a fraction of the fees, taking away business from competitors with traditional branches to maintain. These digital banks have helped wipe out forex desks at airports, slashed costs on using payment cards overseas and are now reducing business transaction costs. We’ll assess the Revolut IPO when it comes."}],[{"start":387.421,"text":"There are opportunities in financials, but current valuations are not as compelling as they might seem. And this isn’t a sector for the faint-hearted. Personally, I find it easier to invest elsewhere."}],[{"start":400,"text":"Simon Edelsten is a fund manager at Goshawk Asset Management"}],[{"start":405.6,"text":""}]],"url":"https://audio.ftcn.net.cn/album/a_1793430912_6421.mp3"}