Investors considering buying into the banking sector need to know and understand the key items that will have an impact on share prices.
Banks remain popular with institutional investors despite the calamitous events of the past decade. While catastrophic losses have battered the sector - and continue to do so - investors are attracted by the traditional status of banks as good dividend payers.
What should investors look for in order to make an informed judgment on dividend potential? Investors need to look at a relatively small number of metrics in order to make that decision: dividend yield, dividend cover and expected dividend growth.
- Income: how much is the bank earning?
- Where is it coming from both in terms of products, geography and sectors?
- Interest income on personal loans, mortgages and credit cards?
- If so, are the margins appropriate to the risk involved?
- Is it fee income?
- If fee income, are the fees a one-off or recurring? Penalty charges? Commission?
- What is the trend in income? Up? Down? Steady? Rapidly growing? Rapidly falling?
- A bank will ask for at least three years of figures when considering a loan application. Investors would be well advised to do the same before parting with their cash.
- And they should bear in mind that banks are more adept than most at window dressing to flatter their figures on any given date.
Yield, cover and growth
Dividend yield is the most recent dividend payment expressed as a percentage of the current share price.
At the time of writing (12 May 2017) the Financial Times lists The Royal Bank of Scotland yield as zero (it is still making losses and can't pay dividends). Lloyds Bank is listed at 3.37%. HSBC is 6.13%. Barclays, struggling with management and reputational issues, is 1.45%.
Dividend cover is the amount of times that earnings cover the dividend payment; twice is regarded as a market norm but this is not set in stone. Expected dividend growth is self-explanatory: the forecast for future growth in the dividend payment.
In a perfect world the yield and cover would remain constant in arithmetical terms as growth takes place. But as the world's banks have been reminded in recent years, the world is far from perfect.
Costs and provisions
- Are costs rising? Falling? Steady?
- What is the cost to income ratio? What is its direction of movement?
- What is the bank's provisioning policy?
- How much does it routinely set aside against bad debts?
- Is that cash or percentage figure rising or falling?
Bear in mind that provisions for bad debt do not mean that the debt in question will be bad. Provisions against debt that turn out to be unnecessary will either be written back and flow straight into the bottom line, or reduce the need for future provisions.
Beyond the dividend
Moving beyond the dividend, investors need to take into account a broader range of numbers to assess the underlying quality of the institution concerned. Yield, cover and growth all depend upon levels of capital and the strength of the underlying business.
Banks are arguably more exposed than other forms of business to the economic and political fundamentals of the economies in which they operate. This is probably because there are so many elements over which they have no control.
These include the level of interest rates, the expected direction of travel of interest rates, economic growth, economic forecasts and general levels of confidence.
The bigger picture matters more to banks than to most businesses. Once losses begin to mount, and confidence begins to falter, banks can fail unusually quickly. Lehman Brothers and Northern Rock are two very different examples of this phenomenon.
The word 'credit', remember, derives from the Latin word 'credere', to believe. Once depositors and other creditors stop believing in a bank, its days are surely numbered.
Capital and transformation
- Leverage: how much of the bank's total liabilities is bona fide capital and how much has been borrowed in one way or another?
- Minimum capital levels should be set and monitored externally. Leaving banks to set their own capital requirements is like putting King Herod in charge of babysitting.
- Transformation ratio of deposits into loans: long-term experience suggests banks should keep capital close to hand equivalent to around 10% of total deposits to satisfy day-to-day repayment demand from depositors but that does not mean 90% of total deposits can be lent. A figure above 40-50% is enough to raise some eyebrows.
- The Airdrie Savings Bank, the UK's last independent savings bank, boasted a transformation ratio of around 3%, making it possibly the most conservative bank in the developed world. It is in the process of closing down.
Where is the growth?
In addition, the largest banks in any given developed market already enjoy such a large combined market share that there is little obvious room for the core business to grow. This can give rise to danger.
As with any industry, sudden large shocks will hit share prices, fast and possibly savagely. A move into non-core areas, whether in terms of products or geographic location, can be a clear precursor to trouble.
All too often it is clear only in hindsight to those initiating the move. Anyone who raises an objection is labelled a Cassandra, after the Trojan woman whose forecasts of doom were universally dismissed. Remember, though, that Cassandra was proved horribly all too right.
Consider the determination of banks to sell inappropriate payment protection insurance to customers, even if the customer didn't ask for it, or even need it.
It is scheduled to cost Lloyds Bank something in the region of £17.4bn at the last time of checking, with still a bit more to come. The mis-selling of so-called structured products is another bug starting to come out of the woodwork.
Organic or bought
- Is growth organic or by acquisition?
- If the former, what are the prospects for future growth?
- If the latter, has the bank demonstrated it can buy well and integrate successfully?
- If buying overseas, does it have proven expertise in the jurisdiction of the target company that it can transfer? Or will it rely on existing management?
- If buying into a new geography, does it risk attracting the business that established players have declined?
- Does it risk building up a customer base that is unreliable and unprofitable?
- Does it risk building a loan book quickly too quickly in the search for rapid growth?
- Does the business being bought perhaps have legacy issues that could cause losses at a later date? Did the buying bank seek indemnities against such a possibility?
Even PPI hasn't proved fatal, demonstrating what can be the extraordinary resilience of large retail banks. Once they stop making large provisions, they become money-making machines, throwing out cash in all directions.
I have personally been recommending Lloyds Bank and RBS as long-term, very long-term investments for several years now.
Lloyds is still in a recovery phase, but resumed paying dividends in 2015 and in May reached the end of its days as a nationalised entity, earlier than once expected.
This removal of a strong element of unwelcome political risk should help to further reassure institutional investors. RBS must look on with envy.
Regulation and IT
- Banking has become an enormously regulated industry in recent years: does the bank under consideration understand the requirements of regulation and have processes in place to be regulatory-compliant in a cost-effective manner?
- What impact has regulation, often uncertain and conflicting, had on new and existing business?
- Will the Dodd-Frank act be repealed, as US president Donald Trump has stated, enabling banks to grow bigger?
- Or will the president, as he has said separately, break them up because they are too big to fail?
- Has it successfully adapted to the new much stricter regime?
- Is the bank's information technology state of the art, robust and reliable?
- Has it been revised and rebuilt in recent times?
- Or does it date back to legacy system foundations from the 1960s, with successive ad hoc add-ons, everything held together by sealing wax and strings?
Financing and staffing
- Look at the structure of the bank's financing.
- Is it retail, wholesale or a healthy mix? Is it long-term, medium-term or short-term?
- Staff numbers can give a clue to a bank's culture. Are numbers rising, falling or stable?
- What is the annual churn rate?
- If very low, this could indicate a happy bank. But it could also indicate a complacent bank where staff know their job and can coast by on minimum effort.
- If high, it could indicate the bank is an unattractive place to work and cannot keep staff.
- On the other hand, it could indicate that the bank has a staff development and training programme that make its trained staff more attractive to rivals.
- Do sponsorships represent an appropriate spend of marketing budget in a way that benefits both the giver and the recipient?
- Or do they suggest that the chief executive officer has been smitten by celebrity?
- Is the bank local, regional, national, international or global?
- Is it too diversified and too big to manage?
- Is it too specialised, limiting room for maneouvre and growth, perhaps even specialising itself into extinction? (see Airdrie Savings Bank above)
Senior management succession planning
- Does it even exist?
- If it does, is it internal or external in nature?
- Is the CEO a retail banker, a corporate banker, an investment banker or a non-banker?
Signs that say walk away
- If compliance officers are resigning in significant numbers, walk away.
- If a bank has joint CEOs, walk away.
- If someone says 'this time it's different', walk away.