- Screamingly cheap shares amid market angst.
- Highly profitable, low-cost banking model.
- Strong growth powered by market share gains.
- ‘The loan-to-value ratios on its mortgages are in the region of 60% and the rental market is very strong. So, we feel landlord default is a remote possibility’ – Richard Penny, Crux Asset Management
When investor unease about a sector takes hold, the resulting selloff tends to be brutal, widespread and often undiscriminating. And so it was in March, when the US regional banking crisis began in earnest, and shareholder nerves spread like wildfire across the pond and to other, seemingly unrelated lenders.
The initial crisis was triggered by specifics, namely the collapse of Silicon Valley Bank. The former tech sector lending darling suffered heavy losses in its bond portfolio in the wake of a series of US interest rate rises and was then hit by a catastrophic run on its deposits while trying to raise emergency funds.
As the tumult unfolded, however, it rapidly became a less clear-cut crisis of confidence, which arrived in Europe with a bang in April when Swiss regulators hastily brokered a $3.25bn rescue takeover of Credit Suisse by its long-standing rival UBS.
In the UK, all of the big names suffered from the fallout, irrespective of the health of their balance sheets or the behaviour of their customer deposits. Over a nail-chewing few weeks, also beginning in March, the FTSE 350 Banks index lost more than 16% of its value; it has yet to fully recover its previous levels.
Caught up in the sell-off was AAA-rated OSB Group (GB:OSB), the London-listed specialist mortgage lender whose shares, ironically, had only a month earlier been approaching record highs. The £2.1bn buy-to-let specialist shed as much as 18% of its stock market worth during the March carnage, only beginning to recover ground on the back of reassuringly strong financial results. While the shares have recovered some of their poise, they are still trading at a discount relative to the FTSE banks index.
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There are plenty of legitimate reasons for investors to feel edgy about the financial sector in general. Inflation, the cost-of-living crisis, rising interest rates, economic uncertainty, and fears about the fragility of the housing market, for example, all raise the prospect of a potential increase in customer debt arrears or even outright defaults. Yet on the face of it, OSB’s lowly rating on the stock does appear a little confounding.
Richard Penny, an elite manager at Crux Asset Management, says: ‘The banking crisis has led to a kneejerk selloff of all banks. A second-tier bank such as OSB is usually worst hit. This ignores the fundamentals. The loan-to-value ratios on its mortgages are in the region of 60% and the rental market is very strong. So, we feel landlord default is a remote possibility.’
Penny is one of eight elite managers holding the stock, drawn to the bank’s superior growth and returns on equity coupled with an inferior valuation to rivals. Such are the sizes of their bets that, based on Citywire Elite Companies’ unique conviction methodology, OSB Group is these top portfolio managers’ favourite UK lender.
Top five elite holders
Sources: Citywire / Morningstar, latest holdings data.
Multiple mergers
OSB’s history is potted with mergers and acquisitions. The group traces its roots back to 1898 and the creation of the Chatham & District Reliance building society, with offices in Gillingham, Kent. Following a merger with three other societies, the company changed its name to the Kent Reliance in 1986. In 2011, it changed its name again, to OneSavings Bank, after private equity investor JC Flowers bought a stake and a new business structure was formed.
Several mergers later and having moved into the buy-to-let mortgage market, the group floated its shares in London in May 2014. Then, in 2019, it merged with Charter Court Financial Services, a buy-to-let competitor that was also listed, changing its name to OSB Group the following year.
Although the company specialises in professional buy-to-let mortgages, it also offers services to those denied finance by mainstream lenders and offers funding to housebuilders and property developers.
As well as saving products, including ISAs and bonds, it provides asset financing for small businesses and other corporate customers. It operates a string of brands, including Precise Mortgages and Charter Savings Bank, and has a wholly owned subsidiary, OSB India, which is based in Bangalore and Hyderabad, India and provides low-cost operational support including IT, risk and compliance and marketing.
OSB effectively reports along two business lines. OneSavings Bank arranges buy-to-let and commercial mortgages, specialist lending and asset finance. This is done through a network of brokers and independent financial advisers rather than costly branches. It carries out its own underwriting process and has a strong reputation thanks to its loan book’s robust performance during past downturns. Its main brand, Kent Reliance, also acts as its main source of funds through savings.
The other business line, Charter Court Financial Services, is a buy-to-let and retail savings specialist and is mainly funded by Charter Savings Bank.
Together, the two arms have an underlying book of loans and advances that was worth £24.2bn at the end of the first quarter, almost three-quarters of which consists of buy-to-let mortgages. And the group’s shares are a constituent of the FTSE 250 index with a market capitalisation of just over £2.1bn.
A buy-to-let bet
| Key facts | |||
|---|---|---|---|
| Market capitalisation | £2.23bn | Price | 526p |
| Net cash / debt(-) | £-5.38bn | 52-week high/low | 599p / 367p |
| F’cst price-earnings ratio | 5.2 | F’cst dividend yield | 6.8% |
| F’cst price-to-tangible book value | – | 3-month share price return | -2.0% |
| F’cst return on tangible equity | 20% | Leverage ratio | 12.5x |
| 5yr sales CAGR | 26% | 5yr EPS CAGR | 12% |
| Forecast EPS growth | 2.9% | 3m forecast EPS change | 3.7% |
Source: FactSet. Price-to-earnings ratio, EPS growth and dividend yield based on 12-month forecast earnings. EPS = earnings per share; CAGR = compound annual growth rate; Ebit = earnings before interest and tax
| Year end 31 Dec | Sales (£m) | Pre-tax profit (£m) | EPS (£) | DPS (£) |
|---|---|---|---|---|
| 2020 | 570 | 301 | 0.58 | 0.14 |
| 2021 | 679 | 523 | 0.87 | 0.26 |
| 2022 | 824 | 565 | 1.00 | 0.31 |
| f’cst 2023 | 824 | 544 | 0.97 | 0.34 |
| f’cst 2024 | 855 | 565 | 1.07 | 0.37 |
Source: FactSet, adjusted earnings figures, data as of 26 Jan 2023. DPS = dividend per share.
Banks tend to be viewed as plays on their domestic economies, whose fortunes fluctuate in line with those of their customers and the ebbs and flows of economic cycles.
In some ways, OSB seems to fly against the winds of that particular assessment. For a start, its net loans, which are predominantly to professional landlords that operate their businesses inside a corporate structure, have grown at a compound annual rate of 9.3% to £23.6bn in the three years since the completion of the merger with Charter House. Deposits, where customers will be spread more widely, have at a compound rate of 6.8% over the same period to £19.8bn.
The high growth rate relative to larger rivals can be attributed to OSB’s niche focus, which allows it to win share from uninterested and slower-moving big banks.
Meanwhile, from the first full year following the completion of the merger in 2020 to 2022, there has been a 44% rise in net interest income to £769m as net interest margins have increased from 2.47% to 3.03%. Net interest income is the difference between the interest a bank receives on its assets (loans made) and the amount it pays out on liabilities (deposits held).
The low-cost model also means OSB is extremely effective at turning net interest income into profit. Underlying costs as a percentage of income stood at 25% last year, against 55.5% for NatWest and 50.4% for Lloyds. This is a testament to its operational efficiency and ability to keep the lid on administrative expenses, including by outsourcing tasks to OSB India.
All this feeds into the group’s underlying return on tangible equity – a key measure of how efficiently banks generate profits – of 19% which compares very favourably to larger rivals with high-single to low-double-digit returns.
But despite all its very desirable characteristics, OSB shares look cheap, even by the standards of its lowly rated sector. It is valued in line with tangible book value and at 5.2 times forecast EPS. The fat forecast dividend yield of 6.8% also beats most peers.
The question is: why? Angst about the buy-to-let market offers an answer, but worries could be overblown.
Let it be?
Recent reforms to buy-to-let regulation and tax treatment have produced negative headlines. However, so far the buy-to-let market has held up surprisingly well.
According to UK Finance, a total of 315,913 buy-to-let loans were made last year for a total value of £55.7bn, up from 281,775 loans worth a total of £47.5bn for 2021. Separate figures from the trade body show that, by number, buy-to-let loans accounted for 12.8% of all mortgages. That demonstrates how embedded the market has become.
However, more recent data from UK Finance points to a softening in the buy-to-let market and the most recent estate agent survey by the Royal Institution of Charted Surveyors included many comments about landlords folding. The sentiment is not helped by expectations that interest rates will need to increase further than previously expected to tame inflation.
But buy-to-let investors come in all shapes and sizes, and the majority of OSB’s customers manage a portfolio of homes inside a corporate structure that allows them tax exemptions on mortgage interest payments that have been withdrawn for amateur landlords. These professionals look much better able to cope with tougher market conditions, especially given the low average loan-to-value of OSB’s borrowers and its strong historical record as an underwriter.
Nor should we lose sight of the additional cushion offered by the rapidly growing rental market, which is flourishing in part because of the high bar of affordability on properties in the UK. Rising demand and a scarcity of rental properties are pushing up rents, and therefore rental yields for landlords. The average gross rental yield – essentially all income before expenses – on a buy-to-let property was 6.39% in March, according to UK Finance. That’s comfortably ahead of the average interest rate on related mortgage loans at the time of 4.92%. The difference is clearly not pure profit for landlords, but it does imply that, as borrowers, they are not a bad bet.
And even if the market sees a slowdown in new borrowing, OSB’s record of winning share should help mitigate some of the pain. And there is still plenty of share that could be taken. OSB claims it nabbed about 7% of last year’s new buy-to-let business.
Crux’s Penny says: ‘OSB is a second-tier bank but scalable in its niche of professional buy-to-let mortgages … The buy-to-let market is benefiting from strong rental prices and has a very strong record with its professional buy-to-let mortgage providers. This should mean low bad debts and a much lesser chance of binary risk in some large banks.’
Brought to book
The loan book currently looks in good shape. As of the year-end, just 1.1% of its outstanding balances were in arrears of more than three months, a period after which lenders start to question whether a loan is going badly wrong.
And at the same point, the bank’s underlying loan loss ratio – effectively the proportion of its loans book that it believes is unrecoverable – was just 0.14%, leading it to take an impairment hit of £30.7m. Bearing in mind the underlying value of the net loans book stood at £23.5bn, that seems reassuringly low.
NatWest’s impairment losses represented just 0.09% of its gross customer loans last year, but the bank is guiding that they should come in at between 0.2% and 0.3% over the current economic cycle. Lloyds’ asset quality ratio, effectively impairments as a percentage of loans and advances, was 0.32% last year. However, in truth, a direct comparison doesn’t really work here because of the differing size and nature of all three loan books.
There are two other bank-specific characteristics of OSB that are worth mentioning. The first is that its large deposit base relative to the size of its underlying loan book – £19.8bn against £23.5bn as of the end of the year – means it is not reliant on the wholesale markets for funding, a problem that brought several banks low during the global financial crisis. If banks are not able to fund their new business, they can no longer provide loans and credit to new and existing customers and will rapidly spiral into crisis.
The second, related, quality is the strength of its capital position. OSB Group’s Common Equity Tier 1 ratio – essentially, what portion of its asset base consists of easily accessible capital – was 18.3%. This large buffer – it is comfortably ahead of both NatWest and Lloyds – means the group should easily be able to withstand substantial financial and economic shocks, including substantial calls on deposits.
Value or value trap
Standing back, then, OSB Group seems to have a lot going for it as a financial services business. The main markets it is exposed to currently appear resilient, and it looks to be financially strong enough to deal with it if they turn out not to be, in a recession, say, or a market crash. While it is an established player, there is also plenty of room for it to grow its market share and its collection of professional landlords are loyal. And on a range of financial measures, it scores well.
The presence of several ESG funds among OSB’s elite holders also points to the view the bank makes a positive contribution to society. That may seem strange given it is part of a sector that tends to be loathed by its customers and regularly falls foul of regulators; OSB in particular serves a clientele that can sometimes be hated by tenants.
Penny, though, makes the argument that the bank helps landlords to provide housing to a UK market with a chronic shortage of stock. It seems a fair point: an even more limited supply of homes would drive rents ever higher and it is not the fault of lenders that property prices for so many are unaffordably high.
Penny adds: ‘Many buy-to-let landlords will refurbish a housing stock which by European standards is older and needs maintenance.’ In the best of worlds, then, one where landlords are careful owners, a case can be made that buy-to-let lenders are catering to a need and helping to solve a problem.
While one can point to reasons for the cheapness of OSB’s shares, it is also easy to see why so many elite managers believe they are overblown and are betting big on the stock. With earnings per share expected to make strong gains over the next few years, without a big economic spanner getting in the works, if the stock stays where it is it will start to look even cheaper while the yield will balloon.
