The last time we suggested that the recovery of the UK’s banking sector was taking so long the market might well have stopped paying attention, in Sneaking up, we likened the situation to the frog in the pan of slowly-heated water – only with, potentially, a much more upbeat ending. On reflection, a happier metaphor than boiled amphibian would have been the changing of the seasons.
If you compare a typical November day with one in May, of course, the differences in temperature, light and so on will be immediately apparent and yet the changes from day to day are barely perceptible. That is not to suggest all is sunshine and warmth for the banks – only that, whether the market is able to see it or not, the outlook is a lot less chilly than it was.
The regulatory headwinds, the apparently never-ending stream of fines for PPI misselling and other poor behaviour, the Government’s stakes in Lloyds and Royal Bank of Scotland – the arguments against investing in the UK’s banks are now so well-rehearsed it can sometimes feel as if the wider market is unable to imagine buying into the sector ever again.
That situates it firmly in value investor territory and yet, here on The Value Perspective, we believe we are nearing a point when the wider market will finally see those arguments need revisiting. We are, effectively, coming to a denouement on this story – a point where, for example, it is less of a stretch to picture what it might be like without the PPI cloud hanging over Lloyds.
As for that issue of Government ownership, take a look at the chart below, which comes from an interesting note on Lloyds by the financial analysts at Autonomous. A selling programme that began in steps has moved to more of a dribble – to the extent that, if it continues at its current daily rate, the Government’s stake will be down to 5% by the end of the year, which is neither here nor there.
Autonomous also notes the possibility that Lloyds may be hitting “something of an air pocket as the investor base transitions from a value-focused one to an income-focused one”. As you can see from this next chart, the firm believes that next year could see Lloyds accounting for 5% of every penny paid in dividends across the whole of the FTSE 100. Nor does the consensus particularly disagree there.
Perhaps understandably, the Government’s stake and a lack of dividend has meant Lloyds is no longer the fixture it once was in UK equity income funds. Here on The Value Perspective, however, we are convinced that, once it is recognised both those situations are changing materially and the bank is reclaiming its place as a natural income-paying stock, it will have a big impact on Lloyds’ share price.
One way to run an equity income fund is to buy stocks with high dividend yields and then hope they are sustainable. It is not the way we invest ourselves – almost by definition, high dividend yields are not sustainable – but even one pay-out of 7% or 8%, say, can provide a real boost to a fund’s own capacity to distribute income.
But there is another way of thinking about equity income. Rather than worrying about which stocks might pay a high dividend and to what degree that is sustainable – a course of action that is leading a lot of managers currently to sniff around the commodities sector – why not consider businesses that pay little or no dividend at all and examine to what degree that situation is sustainable?
With Lloyds to the fore, the UK banks are classic examples of this sort of stock and yet most managers do not think or screen stocks in this way. As a result, they are completely overlooking a great source of potential dividend growth – perhaps not irrespective of the economic outlook but, we believe, even if things do take a turn for the worse.
As value investors, when we analyse a business’s accounts, it is second nature for us to look out for potential risks or concerns. Taken in isolation, none of these ‘red flags’ may be enough to put us off the stock but the presence of half a dozen, say, would strongly suggest we take our search for value elsewhere.
Well, this is the opposite. In our view, ‘green flags’ are popping up all over the UK’s banking sector. Up to now, few investors have noticed and valuations have not moved much as a result. Slowly but surely, however, the seasons are changing for the sector. It may not be shorts and T-shirt weather just yet but things are definitely warming up.