• Alex Harrison

Why Bank Stocks Are Just Too Irresistible At The Moment

Banks, for the last decade, have taken an absolute hammering from regulators, investors and customers alike. It's not surprising that share prices are depressed: Tier 1 Capital requirements mean that banks can’t leverage as much as they could before, with regulatory scrutiny and poor economic conditions further pushing prices downward.

The one thing that keeps me interested in banks is that the global financial system is their construct. This means that they're always going to be long term winners, because you can't play a game of chess without the board and pieces. In the same way that the global financial system can't function without banks’ assistance or say so.

Banks are quite literally money printing machines: making them integral to the infrastructure of global economies. The difference between what they pay in interest to savers and charge in borrowing costs on loans is at another all-time low on the former, initially concerning investors with regard to net income potential. Net income is effectively the gross profit of a bank, and useful for understanding banks income without running costs deducted. Naturally, you're looking for a higher ratio when considering an investment, and bank stocks proved the skeptics wrong here.

“Capital levels are so strong that even if the banks [experience big losses] they will still be OK. You want to own banks.” – Patrick Kaser, CIO of Brandywine Global Investment Management.

Take Citi Bank as an example, who in the worst financial crisis in living memory, reported net income of $2.4 billion and $1.3 billion in the first two quarters of this year: providing net income ratios of 9.56% and 5.65%, respectively. It’s easy to see that a lot of the concern over bank performance has already been built in to the share price, because Citi stock - at the time of writing - is down 45% from the start of the year despite far exceeding profit expectations.

Figure 1: Market (S&P500) vs Main bank stocks (KBW Bank Index)

A perfect storm of being an integral market player and still trading at low prices? I’m in.

Aside from banks’ central role in global economies, another reason to enter financial stocks is their current Book Value (BV): calculated by looking at assets minus liabilities. This brings you the value of a bank in monetary terms and is important when assessing how much upside you’ve got.

Most banks are currently trading at prices substantially lower than their book values, and in my opinion, impairment risk is responsible for widening this gap between share values and reality. Banks are publicizing huge impairment charges (loss in asset value) through their financial accounts, and although these could certainly get worse before they get better, I still believe these costs have been over-built into share prices because of one main reason: the market isn’t considering government support.

The insane amount of governmental aid given to commercial loans have immensely de-risked banks: with Barclays alone issuing over £22 billion worth of government-backed lending. In other words, with government cash, commercial lending is now as low-risk as it can possibly get: and banks will continue leveraging this to their advantage. This advantage can already be seen with Barclays in two ways:

A) even after making provisions for £3.7 billion in potential losses, the UK banking giant was still able to produce a profit of £1.3 billion.

B) the government support along with other strong fundamentals give Barclays a Book Value of 284p per share, against the current price of 107p: a 165% return if shares reach the former level.

This story of 100+% in upside potential is repeated by banks with solid fundamentals the world over: providing an attractive entry point for investors – including myself – looking to pick up undervalued names.