- UK banks are predicted to have a difficult time in 2024 as interest rates fall
- Interest rates falling means profit margins will be squeezed
- The stocks are trading at low valuations and offer well-covered dividend yields
Shares in Britain’s big banks are cheap, argue the value fund managers who hold them
But are they cheap for a reason and due a bumpy ride in 2024 due to interest rates falling, as the broad market consensus holds, or undervalued and primed to bounce back, as some contrarian stock-pickers believe?
Analysts believe that outperformance of UK, European and Japanese banks seen in 2023 is set to reverse this year.
Rising interest rates throughout 2022 and 2023 boosted bank earnings and share prices, leading to an ‘exceptional’ rally according to analysts at Liberum – a result of interest rates rising from zero, allowing banks’ net interest margins to normalise and partially reversing some of the post-2010 bear market.
Now, that bear market is set to return. Liberum says: ‘As we roll into 2024 and the rate cycle appears to be at or near its peak, we believe the structural bear case will reassert itself.’
It comes as the Chancellor met with five of the UK’s biggest bank bosses to discuss their weak share prices and how to boost their stock market value.
Banking heads at Barclays, HSBC, Lloyds Banking Group, NatWest Group and Santander UK met with the London Stock Exchange Group, the Chancellor and Bim Afolani the economic secretary to the Treasury as well as the Chancellor.
Nonetheless, the managers of Temple Bar Investment Trust, Nick Purves and Ian Lance, remain bullish on the case for UK big banks and believe they still make good investments.
The pair back two of the UK’s biggest banks, Barclays and NatWest, which they see as seriously undervalued,
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NatWest occupies a 5.1 per cent allocation in the trust’s portfolio and Barclays has a 4 per cent allocation.
Purves says: ‘We would argue that banks have never been ‘uninvestable’.
‘Warren Buffett’s Berkshire Hathaway has in the past owned banks such as Wells Fargo, JP Morgan, Citigroup, Bank of New York Mellon and USBancorp. Bank of America is currently its second largest position after Apple.
‘So if banks are uninvestable, it would appear that one has bothered to tell the Sage of Omaha.’
UK banks have been deeply out of favour, because they don’t offer the same growth prospects as exciting companies like Apple and Microsoft, which are the current stock market darlings.
But for the income investor, the banks do offer a decent dividend yield with a relatively stable backing.
Laith Khalaf, head of investment analysis at AJ Bell says: ‘I think the big banks are already a reasonable investment if you’re looking for income as part of a diversified portfolio.
‘These are big, heavily regulated companies, whose fortunes are deeply intertwined with those of the global economy, so they shouldn’t be expected to churn out extraordinary earnings growth every year in the same way investors in US tech stocks have come to expect.’
‘Earnings will be cyclical and share price appreciation probably lumpy, but these stocks are trading at low valuations and offering high, well covered dividend yields.’
Purves says: ‘Quality growth investors are sometimes guilty of a sleight of hand in which they claim that a consumer product business, for instance, is a better business than a bank, because it makes a higher return on equity.
‘Whilst this is factually correct, it is arguably disingenuous because it fails to consider the valuation paid to access those returns.
‘When businesses change hands at fractions of their book value, the price paid for ownership can amplify or dampen the returns investors ultimately reap. Simply dismissing a business model out of hand, without paying attention to the price at which that business is on sale is an abdication of one of the key responsibilities of an active manager.’
Banks’ profits have been under pressure for the last few years as interest rates came down and saving rates hit the zero bound but lending rates also continued to fall, putting pressure on net interest margins.
Well-managed banks who are able to respond to technological change, whilst managing their balance sheets with the caution needed when employing borrowed money have a clear investment case. Nick Purves, co-manager of Temple Bar Investment Trust
As rates started to rise again from the end of 2021, this situation began to reverse, allowing banks to increase net interest margins and hence profits again.
A bank’s profits are derived by taking in deposits on which it pays interest, and then lending them out at a higher rate of interest. The difference between these rates (the net interest margin) accounts for a substantial proportion of most banks’ profits
The UK’s biggest banks have come under fire for not passing on the Bank of England’s interest rate rises to savers while ramping up mortgage and other borrowing costs, leading to claims of ‘profiteering’.
To this, Purves says: ‘Whilst it might be convenient for politicians to try to make banks scapegoats for the cost of living crisis, banks are under no moral obligation to hold net interest margins down.
‘Regulators, on the other hand, should be interested in them building their capital ahead of any increase in loan losses associated with an economic downturn and certainly should not be setting a targeted level of profitability.’
Most UK banks are trading at very low valuations. NatWest’s and Barclays are both on a price-to-earnings ratio of 4.3 looking at trailing 12 months actual earnings
Liberum says: ‘History teaches us to be wary of optically cheap valuations.’
The issue of low bank valuations is not unique to the UK though, and we have seen this across Europe.
Purves continues ‘If management are able to prove shareholders wrong by continuing to increase profits, long-suffering shareholders should finally be able to see a positive return.’
With interest rates widely expected to come down later this year though net interest margins will be compressed.
Khalaf says: ‘Falling interest rates, should they materialise, will be negative for net interest margins, but at the same time will be positive for bad loans, and through 2024 we may see banks trimming their provisions for defaults.’
Big tech knocking at the door is not a threat
Big tech and AI have long had their sights set on the banking sector given its data-rich nature and poor customer service experiences.
The managers of Temple Bar see no evidence that banks are being badly disrupted by fintechs though.
Purves says: ‘Many fintechs have been launched in the past decade to much fanfare but the core banking landscape in most countries has not shifted much as a result.
‘For example, NatWest had 19million customers in 2022 – the same number it had in 2016. The story is the same with other large UK banks, with scant evidence of mass customer churn due to fintechs.’
Purves adds: ‘Big banks are incorporating and adapting fintech approaches to change the way they interact with their customers – a point investors afraid of fintech innovation forget.’
Don’t just look at leveraging
Analysts believe the quality of bank loan books is much higher than historically, with regulation and supervision having encouraged a more conservative approach.
Whilst return opportunities do exist for bank investors, some feel they do not sufficiently reward shareholders for the risks given the highly leveraged nature of the business.
Purves says: ‘Whilst leverage brings with it risks, it is important to consider what companies do with the process of that leverage, and how they employ it in the context of a wider business model, before reaching conclusions about how risky that borrowing really is.
‘Looking at default rates by sector observes that banking has one of the lowest cumulative default rates over a ten-year horizon at 4.2 per cent, whilst durable consumer goods, retail and healthcare sat at 25.6 per cent, 24.3 per cent and 10.4 per cent respectively, all sporting far higher risks for investors.
‘Well-managed banks who are able to respond to technological change, whilst managing their balance sheets with the caution needed when employing borrowed money have a clear investment case,’ says Purves.
Income seekers might want to take a look at the UK banking sector, but with such a cyclical industry it’s important to hold it as part of dividend portfolio which has plenty of exposures elsewhere too
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