Image source: NatWest Group plc
Are UK banks’ share deals hiding in plain sight or potential value traps?
Since many of the companies trade on low price-to-earnings (P/E) ratios and offer juicy dividend yields (such as 6.2% Lloyd’s and 5.9% of Barclays), this could be a potentially cheap time to purchase such shares.
On the other hand, there are increasing signs that bank profits may fall in the coming years. That could potentially hurt its value.
This week several banks released trading updates that contained some disturbing hints about the direction of the business.
So how could I decide whether or not to add bank stocks to my portfolio right now?
<h2 class="wp-block-heading" id="h-how-to-value-banking-stocks“>How to value bank stocks
When a stock looks cheap but may not be, how can you value it?
Although many UK bank shares trade at low P/E ratios (Barclays sells for less than four times its earnings, for example), a more common way to value shares in the sector is on price-to-book basis. On this basis too, many British banks look cheap at current valuations.
The challenge is that such metrics use retrospective data. But if there is an economic downturn that reduces loan repayment rates, for example, both earnings and book value could fall. If loan defaults rise sharply, profits could fall dramatically.
So whether bank stocks are really the bargain they may seem right now depends on what happens to the companies’ financial performance in the coming years.
Weighing some pros and cons
As an industry, the UK banking sector tends to move broadly in one direction or another, with little middle ground. That said, big banks are not all the same. Natwest is heavily focused on the UK, for example, while Barclays has a large investment banking operation as well as a retail division.
At a simple level, it is difficult to imagine that any significant decline in the health of the UK economy would not hit the profits of the country’s big banks. In my opinion, the opposite is also true. When the economy is doing well, it should be fairly easy for any well-run bank to make money.
When looking at recent business updates, a common theme is the increase in loan loss provisions. In Natwest’s third quarter trading report published today (27 October), for example, impairment losses for the first nine months were more than double their level in the same period last year. The bank said: “Economic outlook and subsequent customer behaviors remain uncertain.”
On the other hand, banks remain solidly profitable and are generally optimistic about their prospects. Although provisions for loan losses are increasing rapidly, they are within historical norms.
Potential opportunity but also risks.
If those strengths continue, including bank stocks in my portfolio now and for the long term could be a smart move.
But my concern is that the economy is out of the banks’ control and when it starts to struggle, so do the banks.
I think bank stocks look cheap because investors are nervous about that risk and what it means for earnings. This week’s trading updates have contained multiple alarms about the likelihood of increasing loan defaults. I am uncomfortable with that risk and have no plans to buy bank stocks for now.
