Four reasons to own Lloyds and other bank shares

Hugh Sergeant, head of Value & Recovery strategies at River & Mercantile, explains why he owns bank shares, his two favourite ways to play the sector, and why Lloyds (LSE:LLOY) shares could double in value. He also names one of his small-cap bargain shares.

Lee Wild, head of equity strategy, interactive investor:    

Hello, today I have with me Hugh Sergeant, who manages a number of the River and Mercantile funds, which includes the UK Recovery Fund that appears in the interactive investor list of rated funds. Hello Hugh.

Hugh Sergeant: 

Hello, good afternoon.

Lee Wild: 

A glance at the top 10 holdings in the UK Recovery Fund, it throws up lots of household names, and among them are three banks - HSBC (LSE:HSBA), Barclays (LSE:BARC), and Lloyds (LSE:LLOY). Now, the sector has struggled ever since the financial crisis really, it’s had its ups and downs since then. What’s your view on the banking sector currently and its recovery potential?

• Invest with ii: Top Investment Funds | Index Tracker Funds | FTSE Tracker Funds

Hugh Sergeant:  

As value managers, we’ve not given up on banks like a lot of other fund managers essentially have, but we haven’t, we’ve held an overweight position consistently for the last few years. But we’ve not wanted to overly expose the portfolio to this single sector, or single theme, which is, you know, companies that are potentially exposed to a pick-up in inflation and interest rates.

So, we’ve been overweight, but not aggressively overweight. Where we are today, banks are clearly universally hated, but we do think they will start to perform. They’re, first of all, they’ve very lowly valued. So typically, they’re trading at half their book value, their tangible book value.

And if you look at earning multiples, low single digit earnings multiples in terms of recovery profits, they are coming out of the COVID crisis with their balance sheets apparently very much intact, so very, very strong. So, if you look at Lloyds, for example, a lot of free capital and they continue to grow the amount of free capital, so that’s great.

And then they’re actually starting to grow again, so there’s quite a lot of demand for mortgages in particular, so they’re seeing that part of their lending book grow, and then, we’ve got the potential catalyst of a return to dividend payments, probably into early in the new year. That should be signed off, so that could act as a catalyst.

So yes, very low valuations, the outlook is a lot better than those low valuations would suggest and some potential catalysts coming up over the next quarter or two. 

Lee Wild: 

People have been waiting a long time for Lloyds, there have been lots of false dawns, and obviously, you know, people want to know when there will be this sustainable recovery at Lloyds?

Hugh Sergeant: 

It’s probably fair to say that it’s unlikely that banks will return to their former glories, pre the global financial crisis, just because we’re in a, the background is one of such low interest rates that it’s really quite hard for them to make a sensible, or as high a return on their capital as they might have done in the past. 

Maybe if you look forward five or 10 years when we’ve had a much more reflationary environment, when interest rates normalise, then they could make really attractive returns on capital and a return to formal glory. But even if they don’t return to former glory, then I think they’ve very sensible investments at this point. 

Lloyds’ profits will recover over the next couple of years, dividends will be reinstated, they should be able to grow in certain areas such as mortgage lending and the wealth side. And the shares should at least able to trade at a premium to their book value, and that would suggest from here the shares doubling just to get back to book value. So yes, should be attractive investments from this point.

Lee Wild:  

OK. Of HSBC, Barclays and Lloyds, which of those three has the most recovery potential, would you say?

Hugh Sergeant:

I think a combination of Lloyds and Barclays. HSBC has always been more of the kind Steady Eddie global, it’s not really been that, but it still reflects that a little bit in the higher valuation, not quite as discounted as Lloyds and Barclays have become, so from that kind of perspective, that recovery perspective, those two probably have more upside.

Lee Wild:

Moving to another sector, unloved at the moment, oils, and Shell (LSE:RDSB) and BP (LSE:BP.). Now, I mean investors might be tempted to buy at what are knock down prices, what’s your outlook for the oil sector, and what are very widely owned stocks?

Hugh Sergeant: 

We do own both of those stocks in our portfolios and our recovery portfolio. They’re obviously big constituents of the UK benchmark, and I don’t think we’d be underweight versus the benchmark. But we do think they have significant recovery potential. They are very modestly valued versus their potential profits, cashflow and historical valuation levels. 

And we would expect in the scenario that I’ve painted of economic recovery into next year and the following year, you would expect in that type of environment, the oil price to be relatively firm from the current levels. So, taking all that into account you would expect energy stocks to respond quite positively.

Obviously, the other aspect that everyone’s having to take into account is the sustainability element of investing and clearly energy stocks are at the forefront of that. So, you need to clearly understand how those companies are going to reposition their franchise over the medium term to focus on as much on the renewable side as the carbon production, or at least getting a degree of balance.

So, you’d have confidence in that, but I think BP and Shell have started to articulate a relatively clear passage to more sustainability.

Lee Wild: 

And then, we’ve talked a lot about some large caps in your portfolio, the UK Recovery portfolio, but then there are some interesting small caps as well. Mpac Group (LSE:MPAC), Gresham House (LSE:GHE), Somero Enterprises (LSE:SOM), Eckoh (LSE:ECK), Boku (LSE:BOKU). I just wondered whether you could talk us through some of your favourites.

Hugh Sergeant: 

The recovery strategies have always had pretty significant exposure to smaller companies. They’re very much multi-cap approaches and you can find some real bargains at the small cap end of thing, because of a lack of coverage, and also because of illiquidity, so when they come out of favour, they really go out of favour, at the small cap end.

You’ve mentioned one or two, I might just highlight one, Somero Enterprises (LSE:SOM), so this is a business that we’ve followed for quite a few years. It has a cycle, so we were particularly aggressive buyers of it during the global financial crisis, and now is another interesting point to be buying the shares from our perspective.

The business is actually a world leader, it’s a kind of micro-cap, but it’s a world leader in kit that levels concrete, but really sophisticated levelling, as flat as you can get. And you need this for, in particular, for some of the big warehouses being put up for e-commerce, so you think of an Amazon (NASDAQ:AMZN), for example, they would need their contractors to be using Somero kit, so it’s got a great leading global market position in that, but it is cyclical.

It follows the construction cycle, it’s particularly strong in the US, so we’ve seen a little bit of a downturn during the pandemic, and that’s meant the share prices reflected that downturn and the shares are available on a really attractive recovery earnings multiple. And one particularly strong aspect of the business is that it generates a huge amount of cash, so it doesn’t need to invest in capital expenditure significantly, makes high gross margins, high net margins, little capex required equals a lot of free cash flow generation, ost of which has been paid back to shareholders. 

And then you’ve got the recovery in terms of the construction cycle to look forward to in the US in particular, as we go into 2021-22. So, that’s one of our favourite stocks, small cap stocks at the moment.

Lee Wild: 

Great, Hugh Sergeant, manager of the River and Mercantile UK Recovery Fund, thanks very much for joining us today. 

Hugh Sergeant: 

Thank you very much and good afternoon.

• Explore more fund manager interviews on our YouTube channel

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.