Looking for cheap FTSE 100 stocks?

FTSE 100 stocks, on average, trade at a discount relative to their US counterparts. In fact, the index’s average price-to-earnings (P/E) is around 14, while the S&P‘s is closer to 19.

But one sector that trades at lower multiples to the FTSE 100 average is banking. UK banks have pushed upwards around 20% since last summer, but valuations remain attractive.

So, let’s take a closer look UK banking stocks.

Cyclicals

Banks are cyclical stocks, meaning their performance tends to reflect the health of the economy. So, with the forecast for the UK economy looking pretty gloomy, it’s not surprising to see lower valuations.

During recessions or periods of economic upheaval, banks tend to spend more on impairment charges as debt turns bad. Moreover, when economies go into reverse, there’s normally less demand for borrowing, which in turn impacts lending volume.

It’s different this time

Normally, when economies decline, central banks lower interest rates to spur borrowing and get the economy moving. It’s about increasing money supply.

But inflation is a major issue right now, and it’s part of the reason we’re seeing negative growth forecasts. In this environment, the Bank of England needs to increase interest rates — reduce money supply — in order to bring down inflation.

With the economy already weak, it’s a fine balance between reducing inflation and not causing considerable damage to the UK economy. Although, interest rate rises are intended to reduce inflation and economic activity.

What does this mean for banks?

As we saw in full-year results, published by several UK banks in February, impairment charges came in high. With inflation in double digits, and borrowing costs hitting businesses and individuals alike, bad debt soared.

However, interest rates haven’t been this high in over a decade, and this means that net interest margins (NIMs) — the difference between lending and savings rates — are expanding. This happens because banks don’t necessarily pass higher lending rates on to savings customers.

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As a result, net interest income has surged. For example, Lloyds registered an 14% year-on-year rise in net income. Banks are even earning more interest on central bank deposits.

Valuations

The P/E ratio is by no means the optimal metric for valuing a company. There are lots of ratios and calculations, but the P/E can give us a good idea of relative valuation.

The above table shows us that the UK-focused banks have lower valuations than HSBC and Standard Chartered, which are increasingly operating in high-growth markets.

But all of these stocks trade with P/E ratios below the index average. I actually own all bar Standard Chartered, and I would buy the stock. I don’t normally do this, but I sold Standard Chartered because my returns were already very strong and sometime I cash in. It also offers a meagre 2% dividend yield — much less than the other four banks.

However, I was wrong to sell Standard Chartered, and I’d buy (more of) all of the above stocks for my portfolio. But, as I don’t have the funds available for all five, I’ll be focusing on my favourite, Lloyds, and topping up my position. It’s the most interest rate sensitive, and in the medium term, I see that as a big positive.

The post Looking for cheap FTSE 100 stocks? appeared first on The Motley Fool UK.

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HSBC Holdings is an advertising partner of The Ascent, a Motley Fool company. James Fox has positions in Barclays Plc, HSBC Holdings, Lloyds Banking Group Plc and NatWest Group. The Motley Fool UK has recommended Barclays Plc, HSBC Holdings, Lloyds Banking Group Plc, and Standard Chartered Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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