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Are the banks bouncing back after their fall from grace? And if they are, could this present a brief golden opportunity for investors? Tom Sieber sees if he can catch some falling stars that might be about to rise again

The explosion of greed that resulted in the sub-prime crisis and subsequent credit crunch appeared to have been replaced by a surplus of fear in the first weeks of 2008. The FTSE 100 slipped below 6,000 to a year low of 5,578 and a lot of the weakness could be found in the banking sector – which accounts for more than 14% of the All Share. It reached its nadir on 21 January, having lost 20% since the turn of the year.

Yet despite some pretty bearish rumours, the most eagerly anticipated banking results season for more than a decade did not reveal rights issues or dividend cuts – in fact quite the opposite in a number of cases. Most updates were at least reassuring, and this, especially when set against a backdrop of falling interest rates, raises the important question of whether or not the banks will return to their historic trend of outperforming the market.

By any traditional measure you would say the banks look cheap and low interest rates are traditionally a good sign for them – but we are no longer in the comfortable territory that would have seen the sector labelled boring a few years ago. The past six months have witnessed the first run on a UK bank in over a century eventually result in nationalisation, and market valuations have nosedived while credit crunch-related write-downs have soared.

As an illustration of the hazards involved in judging the sector, many observers, ourselves included, were tempted to tip the banks as recovery plays this year. January did little to prove the wisdom of that advice – although thankfully neither of our picks, Lloyds TSB (LLOY) and Barclays (BARC), slipped through their stop losses.

So were we all just a little premature in our recommendations? Is it still much too soon to buy? And should investors even be holding their positions or are there likely to be more catastrophes to come?

The first half of the banking results season helped to boost share prices but sentiment has shifted since then with rumours of another liquidity crisis and HBOS (HBOS) being flagged up as a potential recipient of emergency funds from the Bank of England. Additionally the bank’s results were badly received by the market and this led to a wider retreat in share prices.

That decline was barely halted by some solid numbers from Royal Bank of Scotland, yet there has been a definite rally – according to broker Killik & Co: ‘The FTSE 100 has gained 260 points since 11 February, the week in which the banks’ reporting season kicked off with Bradford & Bingley’s results. The banks index has outperformed the market by 4% over that period.’

Consistent attributes, shared across almost the entire sector at present, are historically low PEs and high yields. In any normal circumstances the shares would be manna from heaven to value investors. Royal Bank of Scotland (RBS) is on a PE of 7.46 and yields more than 7%, Bradford & Bingley (BB.) looks even cheaper – on a yield of more than 10% and a PE of 6.64.

However, there would be no value at all in just buying into the sector indiscriminately. For a start, it is still difficult to have a great deal of confidence in the earnings estimates on which these valuations are based. Secondly, if the recently released numbers tell us anything it is that fortunes have varied widely since last summer.

On that basis it is worth examining the impact of the sub-prime crisis and resulting credit crunch in more detail and assessing what this set of results tells us about which banks are better equipped to deal with its lasting implications.

An obvious consequence of the turmoil is the erosion of cheap credit. The three-month London interbank offered rate (LIBOR), the daily reference rate at which banks offer to lend funds to other banks on the wholesale money market – recently rose to 5.71% from 5.7%, still some way ahead of the base rate of 5.25%.

This will put pressure on revenues, particularly for banks such as Alliance & Leicester (AL.) and HBOS, which rely heavily on wholesale funding. Another challenge the lenders will face is a slowdown in the UK housing market. And while most observers don’t foresee a similar collapse to that which occurred over the pond, at best the outlook is flat.

Write-downs will continue to be a feature but have probably receded in importance – it now seems increasingly unlikely that the UK will see figures to match the scale of those on Wall Street. The £8 billion hit sustained by HSBC (HSBA) nonwithstanding. The size and diversity of its business, though, means this is more comfortably absorbed. The one remaining question mark in this area is the exposure to monoline and whether or not the monoline insurers, which in turn are exposed to the sub-prime debacle, will see their credit ratings downgraded.

The fate of these companies, which guarantee the repayment of principal and interest in the case of a default on a bond, does seem a little more secure after ratings agency Standard & Poor’s last week affirmed, for now, the AAA rating of two of the largest: MBIA and Ambac.

A measure of the impact of all these problems, which originated in the financial world, is that their effects have spread to the wider global economy – significantly increasing the prospects of a world-wide recession. The UK economy is far from immune – at best it is expected to slow this year, so now is perhaps not the time to be too heavily exposed to the debt-ridden British consumer.

Is big better?

In which case Barclays (Shares 28 February) may be a good bet. Investment banking arm Barclays Capital reported a 5% increase in pre-tax profits to £2.34 billion despite the write-downs, as overall group profits slipped 1% to £7.08 billion. As group president Bob Diamond observed: ‘Only two or three investment banks finished 2007 better than 2006. We are one. That gives us the licence to grow.’

Diamond is aggressively targeting the business left behind by the big investment banks in the US. Whether or not this is a wise move is open to question, but Barclays’ size does offer some insurance.

And despite the negative attention HBOS has attracted for its results, Collins Stewart banking analyst Alex Potter still felt able to observe that: ‘The story of this results season appears to be – big bank: good, small bank: bad. Another large cap bank has dodged the bullets...’

In fairness this probably says a lot more about the problems faced by the two obvious smaller banks – Alliance & Leicester (Shares 28 February) and Bradford & Bingley (Shares 21 February) – than it does about the prospects for HBOS. The owner of Halifax still has funding issues but its sheer size should enable it to ride this out with more comfort than A&L and B&B.

The preference for bigger banks is only likely to become more pronounced after the Fed chairman Ben Bernanke’s observations that smaller banks in the US may fail as a result of the housing slump.

Both Alliance & Leicester and Bradford & Bingley have suffered badly since the run on Northern Rock (NRK) – mainly because there is an assumption that they face similar problems in terms of funding.

Alliance & Leicester found support as we moved into 2008 on reports of bid interest from Banco Santander but that has since disappeared. The results it released last month amounted to a profits warning revealing that increased funding costs and lower lending volumes would hit revenues. Just to add to that miserable picture the buyback was also cancelled and the dividend was flat.

Bradford & Bingley profits were down by half and it announced some unexpected write downs, though it was able to reassure the market with a small increase in the dividend. The fact that it has taken a conservative approach to funding has also left it better able to weather the current storm in the credit markets.

The battering that both banks’ share prices have taken has led to speculation that they may become bid targets. This was supported by comments which accompanied the release of Lloyds TSB’s results (Shares 28 February), suggesting that the bank, which tried to buy Northern Rock, may take an interest in Alliance & Leicester. Merrill Lynch has since observed that the market would respond negatively to any such deal – and hinted that the bank’s attentions may in fact turn to Ireland.

There are definite risks to looking overseas. The successful acquisition of ABN Amro by an RBS-led consortium has led to fears that chief exec Sir Fred Goodwin may have erred in increasing his bank’s exposure to wholesale banking at just the wrong time.

He would strongly dispute that, of course, and the results were used as an opportunity to flag up the cost savings that have already been achieved in this area. But an obvious black mark against the bank is its capital position, which has been constrained by the acquisition of ABN much as it was after the takeover of NatWest in 2000 – this may make it more difficult for management to keep pace with dividend growth across the sector.

Has conservatism paid off?

Lloyds is in a position to go down the corporate route in part because of a business model that has been far from fashionable in recent times. A darling of the sector in the 1990s, it was left behind by the flurry of activity since the millennium, choosing to focus on its UK retail banking division. Partly as a result of this, the size of its exposure to sub-prime is, in relative terms, very small.

If Hector Sands, the head of the FSA, is to be believed, then a return to normality, or at least normality as we know it, is impossible. He suggests that banks’ balance sheets will have to follow a more traditional model, with far less debt being repackaged and sold on. If this is true then Lloyds has the advantage of already being closer to that model than most other UK-listed banks.

In a note published just in advance of the results season, Dresdner Kleinwort said that it favoured HBOS and Lloyds TSB because of their more ‘predictable banking risks’ when set against those attached to the larger markets businesses at Barclays and RBS. Lloyds certainly seems pretty pleased with itself – alongside its results, the bank heralded a cautious approach over the past few years saying: ‘Our prudent approach to risk ensured we experienced minimal impact from the US sub-prime fall-out. We have a strong capital position and this will support the future growth of the business.’

Hichens Harrison analyst Magnus Mathewson is not entirely convinced that the company should be given too much credit for its approach to risk: ‘You have to take account of the amount of money Barclays and RBS made in the good years on these investments. When investors’ attitudes swing from protecting themselves against the downside to looking for upside, Barclays and RBS should benefit.’ But given that the travails in the financial sector largely result from a skewed understanding of risk, perhaps Lloyds has earned the right to crow a little.

Look east?

Even accounting for the case for Lloyds, Standard Chartered (STAN) is clearly the stand-out performer among the banks, and its latest set of results, which were ahead of expectations, will only have added to its attractions. The pace of revenue growth was a scorching 26% – more than double that of its UK peer group and it has relatively limited exposure to the credit crunch. Perhaps most importantly management was confident enough to offer some commitment on earnings, which compares with relatively little guidance elsewhere.

The performance of its Hong Kong business was particularly strong and this bodes well for HSBC – which derives around a quarter of its profits from Hong Kong. In its outlook statement the bank continued to warn that turmoil in global financial markets was ‘far from over’ but also said it was in ‘great shape’ and had ‘great momentum’.

Amid the current uncertainty there is a clear attraction to companies with an emerging markets focus. The IMF forecasts that growth in emerging markets and developing economies will moderate to 6.9% this year from 7.8% in 2007. But this still compares very favourably with a 1.5% expansion expected in the US and 1.3% growth for the eurozone in 2008.

Inevitably Standard’s charms don’t come cheap and the stock is at a significant premium to the rest of the sector, but both it and to a lesser extent HSBC offer exposure to areas of relatively high economic growth.

Does doom mean gloom?

So what conclusions can we draw from this reporting season? Clearly things are not as bad as the doom mongers would have had us believe. Write-downs have to an extent been contained, payouts have on the whole been increased rather than cut and there have been no rights issues. From an investment point of view, however, this will matter little unless market sentiment towards the sector improves.

As noted above the first half of the season saw a rally in financial stocks, but this came to an abrupt end, due to some poor but far from disastrous results from HBOS. Such a reaction hints at the febrile nature of confidence in the banks.

Inevitably there is a lot of investor interest in the sector, as Angus Rigby, the CEO of stockbroker TD Waterhouse, observed last week: ‘Our investors have been lured once more into the banking sector with hopes of juicy yields. Indeed, banking stocks in general accounted for 72% of all our retail investor buys and 68% of our sells over the week.’

Lasting confidence is unlikely to return across the board – the impact of the run on Northern Rock virtually ensures that, and it would be a mistake to expect stocks to return to the peaks of June last year any time soon. However, despite the level of uncertainty, we believe, taking a long-term view, that in some cases there are enough positives to outweigh the negatives that have dogged the sector.

Latest figures

HBOS (HBOS)

Finals PTP: £5,474m (£5,706m)

Divi: 44.5p (37.85p)

Profits were down around 4%, although broadly in line with consensus estimates. The dividend was up a punchy 18%. Profits in retail banking were down by around 13%. Losses from the market turmoil were just £227 million, the lowest of the ‘big five’ UK banks. But £9.5 billion of US mortgage backed securities remain on the balance sheet – £7.1 billion of which are in the Alt-A category – not as risky as sub-prime but still not solid enough to bet the house on.

HSBC (HSBA)

Finals PTP: $24,212m ($22,086m)

Divi: 87c (76c)

Results were slightly below consensus estimates, although the massive sub-prime hit had been flagged by management ahead of time. Profits were up by around 10% and the dividend was up 11%. Earnings were up 70% in Asia, excluding Hong Kong, but the US operation only just limped into the black. Elsewhere, loan growth was around 13%, while the level of deposits was up 22%.

Royal Bank of Scotland (RBS)

Finals PTP: £5,008m (£4,511m)

Divi: 22.1p (17.1p)

The numbers were broadly in line. Profits before tax were up 9% and the dividend was hiked by 10%. A £1.6 billion write off in the core business was supplemented by a further £900 million from new acquisition ABN Amro. Retail banking profits were up around 10% to £2.47 billion suggesting that RBS may have been a key beneficiary of the collapse of Northern Rock.

Standard Chartered (STAN)

Finals PTP: £2,009.67m (£1,618.7m)

Divi: 37.47p (36.69p)

Ahead of expectations with pre-tax profits up 27% Wholesale banking growth was one of the key drivers of full-year results, with operating income up by more than a third and the dividend was increased by 11.7%. Exposure to the sub-prime crisis was limited. The collapse of the Whistlejacket structured investment vehicle (SIV), which accounted for $116 million of a total $300 million write down, is likely to have done more damage to reputation than the balance sheet.

Forgotten banks

While attention has understandably been focused on the major banks during results season, the smaller and more specialised operators in the sector face many of the same challenges as the eight discussed at length here.

Of particular interest are the two main Irish banks, and the two Aim-listed Islamic banks, which offer financial services compliant with Sharia law. Allied Irish Bank (AIB), the biggest lender in Ireland, reported full year results last month. Pre-tax profits were down 11%, although it posted a 13% increase in underlying 2007 earnings as expected. However, it anticipates that growth will slow to a low single-digit percentage this year.

Bank of Ireland (BKIR), the owner of UK lender Bristol & West, is not due to release results until May, but it recently revealed a £50 million hit to its profits and has also revised its growth estimates downward.

European Islamic Investment Bank (EIIB:AIM) did not meet its own expectations as it swung to a loss of more than £4 million for 2007 and said the year ahead would be ‘challenging’. Islamic Bank of Britain (IBB:AIM) is not due to update the market on 7 March – it will be interesting to see how the company has fared, as it faces increasing competition from mainstream banks for its specialised services.

BANKS' RATING

Alliance & Leicester (AL.) 564.5p SELL

Market cap: £2,524 million

Prospective PE 2008: 9.34

Yield: 9.41%

The lender produced arguably the worst set of results of any of the major banks and there is little to recommend the stock – the only possible catalyst could be a bid – but although there has been some speculation linking it with Lloyds TSB, this now looks increasingly unlikely.

Barclays (BARC) 500.5p BUY

Market cap: £34,063 million Prospective PE 2008: 7.61 Yield: 7.16%

While Barclays Capital continued to perform well last year, the reliance on private equity deals suggests that this will be difficult to sustain. And whether Bob Diamond’s aggressive strategy of seeking to take market share from the beleaguered investment banks in the US will work remains to be seen. However, even based on the most negative of assumptions, Barclays looks too cheap and is worth picking up at its current level.

Bradford & Bingley (BB.) 207p HOLD

Market cap: £1,275 million

Prospective PE 2008: 6.57

Yield: 10.3%

Thanks to a degree of prescience on the part of management the funding situation is pretty secure – although this security comes at quite a high cost. Added reassurance can be found in the fact that the buy-to-let market, of which it has a big share, is proving to be resilient.

HBOS (HBOS) 634.5p HOLD

Market cap: £26,333 million

Prospective PE 2008: 6.67

Yield: 7.17%

There are some clear negatives here – namely a reliance on wholesale funding, a leading share in a declining mortgage market and some pretty negative internal noises on its outlook. Despite that the bank has probably reached the stage where it is oversold – and is now worth holding for the dividend, up 18%, alone.

HSBC (HSBA) 780.5p BUY

Market cap: £90,899m

Prospective PE for 2008: 10.4

Yield: 6.16%

The £8.7 billion sub-prime related write-downs shouldn’t detract from booming annual profits and a healthy rise in the dividend. The performance of the Hong Kong division, as at Standard Chartered, was impressive with pre-tax profits of $3,330 million in the first half of 2007 and $4,009 million in the second half of the year. The company’s capital position is strong relative to UK peers and it can use that position to invest in emerging markets.

Royal Bank of Scotland (RBS) 401.75p HOLD

Market cap: £41,378 million

Prospective PE 2008: 6.21

Yield: 8.4%

A 10% hike in the dividend and a 9% increase in pre-tax profits looks good, as does a strong performance on the retail banking side. A credit related write down of £2.5 billion, on the other hand, does not. Coupled with the capital constraints associated with the acquisition of ABN Amro, it represents a mixed picture. The capacity to increase cash returns to shareholders, in particular, will be affected.

Standard Chartered (STAN) £16.85 BUY

Market cap: £24,021 million

Prospective PE 2008: 14.1

Yield: 2.69%

Despite recent weakness the stock remains expensive in comparison with other UK banks but when set against more natural peers in key markets such as Hong Kong and Singapore it is relatively cheap. Credit crunch related write downs were limited to $282 million and in any case the sort of growth on offer here warrants a premium.

Lloyds TSB (LLOY) 463.25p BUY

Market cap: £27,238 million

Prospective PE 2008: 8.79

Yield: 7.83%

Unsurprisingly, given the current environment, Lloyds has been keen to emphasise its cautious approach. This should serve it well in the short term and will allow it to grow its position more aggressively – although as explained above a bid for Alliance & Leicester is unlikely to be well received.