One question investors should ask every time they look at a new set of report and accounts is what has changed? Even if the information about the company contained therein is what you thought it would be – the key points were flagged up in advance, your expectations were well-managed and so forth – when looked at in the cold light of day, compared with five or so years ago, what has changed?
With the UK’s high-street banks, which have just finished reporting their full-year results, the answer is that, even compared with two years ago, a lot has changed. compared with five years ago, however, pretty much everything is different – from the regulatory environment to banks’ balance sheets, managements, corporate structures, capital positions, leverage and valuations.
It is of course possible that all those factors have moved in such a way that the investment case for banks is actually no different to what it was – that while the risks and the rewards may have changed, we remain in exactly the same place. More often that not, however, that just tends to be a lazy argument.
When it comes to banks, people usually have an easier time with the rewards half of the investment equation – the returns they could make once the toxic elements of the businesses have been addressed – and they have been gradually gaining confidence with each set of results issued in the last few years. Where everyone remains focused – as indeed they have been since the credit crisis – is on the risks.
Nevertheless, in light of the available evidence, it is growing increasingly difficult to argue there areas yet undiscovered risks lurking out of sight and off the balance sheet that makes the likes of Barclays, Lloyds and Royal Bank of Scotland (RBS) uninvestable.
Let’s focus on what we actually know. Take the Lloyds results, which came out on 1 March and showed its ‘non-core’ business – the potentially toxic part – has halved in size in the last two years and is expected to halve again over the next two years. That is not to say it is not a risk, it is. But it is a risk that has reduced – and should continue to reduce – at a significant rate.
Furthermore, a lot of what remains in that non-core element of Lloyds’ business is now so aggressively provisioned that, if it all turned out tomorrow to be worthless, the impact on the bank’s financial position would not be catastrophic.
Incrementally, many of the risks surrounding banks – sovereign exposures, bad loans and so forth – are being worked out, with the three greatest concerns now remaining being regulatory, political and macroeconomic. So how are things changing in each of those areas?
On regulation, we look to be moving towards a consensus on measures that, while undoubtedly more challenging for banks than five years ago, are not so onerous they will be unable to make returns. As for politics, despite all the rhetoric that paints banks as ‘enemy number-one’, the government has more interest than most in seeing the sector’s share prices rise so it can sell its stakes in Lloyds and RBS.
In addition, the UK appears to be nearing the stage of what might be called ‘bank-bashing burnout’. Certainly stories on the banks’ results appeared to be further down the media’s news agendas this time and there are parallels, appropriately enough, with all those cold calls about compensation for payment protection insurance (PPI) mis-selling. The first message you received saying you were owed £3,000 may have been exciting but, three years and dozens of messages on, that line has lost its appeal.
As for macroeconomic risks, the reality is banks are by no means the only businesses that will be affected by such extremely bearish scenarios as a break-up of the Euro. Importantly, however, most businesses never saw the credit crisis coming and so, when the world fell off a cliff, they were caught cold.
This time, businesses have had three or four years to prepare for a crisis – to balance their assets and liabilities, put systems in place and pay down debt, perhaps, or build up cash. None of which is to suggest something like a Euro break-up would not be a disaster – of course it would have huge ramifications – but at least banks and other businesses would be facing it with their eyes wide open.
When we look at banks here on The Value Perspective, we see both the rewards and the risks growing steadily more clearly defined. What we do not understand in light of all this, however, is why the banks still trade at less than the value of their tangible assets. If markets start worrying about the Euro again later this year, then of course the shares will come under pressure but we continue to believe that, in five years’ time, people are going to look back with amazement at how cheap banks were in 2013.
For one final insight, let’s return to the subject of PPI. Over the last three years, the total provision Lloyds has made to cover potential compensation claims is £7bn, which compares with a value of £40bn on its entire tangible equity – and yet the bank’s book value has not moved.
Lloyds has taken that hit in its stride – on top of all the other impairments – and just keeps on going. despite all the negative sentiment that continues to swirl around the banking sector, that strikes us as a business that has grown a lot more robust than most people seem to think.