Three funds for bank sector fans

A decade after Lehman's collapse and the start of the financial crisis, there are signs that the banks are bouncing back. Holly Black considers the pros and cons. 

It has been a decade since US investment bank Lehman Brothers collapsed and UK banks plunged into freefall as the financial system was pushed to breaking point. The intervening years have seen banks sell off assets, write off debts and offload entire parts of their business. Huge fines and compensation bills have been paid and there has been a steady stream of scandals and blunders.

Finally, though, it seems the sector is putting its past behind it. Bulls say the industry is going from strength to strength: Lloyds has posted profits ahead of market expectations, while RBS has paid its first dividend in a decade. But have the banks bounced back far enough to win over investors?

Steve Davies, manager of the Jupiter UK Growth fund, thinks so: he has around 18% of the fund's £1.3 billion of assets invested in the sector.

A proxy for economic growth

Jamie Clark, co-manager of the Liontrust Macro Equity Income fund, elaborates further.

"Why would you own a bank? Because it's a proxy for economic growth and demand for credit. The UK has a number of problems, many Brexit-related – but its economy is performing a lot better than many had expected."

Brexit may be a major cloud on the horizon for the sector, but focusing on this alone means ignoring the several silver linings, chief among them the fact that interest rates are finally rising. This should materially help profit margins for banks, which have come under pressure as retail lenders have been involved in a race to the bottom on mortgage rates in recent years.

This is an industry where interest rates and profits tend to move upward in tandem – higher rates mean banks can charge borrowers more for loans and mortgages, while they are not obliged to fully pass on rate hikes to their savings customers.

Another positive is that the last of the conduct issues are almost behind the sector. Barclays and RBS settled fines with the US Department of Justice of £1.55 billion and £3.6 billion respectively, and the deadline for payment protection insurance (PPI) compensation is approaching in August 2019. Total compensation payouts are likely to reach an eye-watering £35 billion by then.

Shaking off these heavy compensation bills means banks finally have some spare cash to start giving back to shareholders. HSBC and Lloyds shares are expected to yield 5.5% this year, Barclays 3.5%, RBS 3.2% and Standard Chartered 2.6%.

What is particularly reassuring is their level of dividend cover – this is the number of times a company's earnings will cover its payout to shareholders, expressed as a ratio, and typically experts like it to be at least two times. Lloyds's dividend cover is a respectable 2.1 times earnings while RBS, Standard Chartered and Barclays all have dividend cover ratios above three times. Only HSBC is missing the mark at 1.4 times earnings.

Digital revolution

Meanwhile, the big five FTSE banks – Lloyds, RBS, HSBC, Barclays and Standard Chartered – racked up profits of £9.3 billion between them in the second quarter of this year. This is their strongest three-month period since the start of 2013. Higher profits mean banks can invest in their businesses. Among their top priorities are digitisation as customers move away from bricks-and-mortar branches to mobile apps and websites.

The migration of customers to online and mobile banking is plain to see. Cheque use is down 16% year-on-year, while the number of account logins from mobile devices is up 20%. Banks that don't invest in their digital offering will quickly find themselves left behind.

There were fears that the big banks would struggle to keep up with newer challengers in their digital offering. While they were bogged down in shoring up their balance sheets, new entrants could start fresh with a low cost base and blank sheet of paper.

But Davies is not concerned about these upstarts. He says:

"If you take Barclays, for example, and look at what its app can do, it's actually very functional compared to the start-ups. There was a fear that challengers would have a significant technological advantage, but it's not obvious to me that this is the case. Banking is different from any other product and there is a huge amount of trust involved; a lot of people won't be comfortable putting their life savings with a start-up."

Instead, he thinks the key to banks' success is in keeping customers' current accounts – something it was feared would become more difficult to do when the Current Account Switching Service was launched in 2013. Actually, surprisingly few people have bothered to change their bank – research has shown that people are more likely to change their life partner than their current account.

Davies says: "Current accounts are very sticky, and when you're not paying for a product the incentive to move is really quite low. So, although we have had challengers appear, their market share is still very small."

Where are the experts investing?

Davies rates Lloyds as the most simple and profitable of the UK banks. A vanilla offering, its bread and butter is UK current accounts, a market in which it has a 27% a share. The main threat to Lloyds is Brexit and any hit to the UK consumer. He also invests in Virgin Money, which has seen its shares rocket more than 40% so far this year, driven by a merger with Clydesdale and Yorkshire Bank this summer.

Clark is avoiding Barclays because of its reliance on investment banking, and RBS because he feels the turnaround of the institution will take longer than its peers. He likes HSBC as it offers global exposure, particularly to the US economy which is 'the vanguard of global recovery'.

He also invests in challenger names such as Close Brothers, a quality operator with a good dividend track record looking for quality rather than quantity of loans, and Virgin Bank, a vanilla company with more mortgage than credit business, offering excellent exposure to the UK economy.

Noelle Cazalis, manager of the Rathbone Strategic Bond fund, has fixed income investments with Nationwide and Coventry Building Society because they have strong balance sheets and high-quality assets. She believes building societies, which equity investors cannot access, have been doing a good job at improving their balance sheets, helped by the fact that, because they have no shareholders, they retain all of their profits.

Clark blames the overall ongoing negative sentiment towards the sector on what behavioural economists would call the 'recency effect', whereby people place too much emphasis on an event because it happened recently. He says:

"The past is no indicator of what will happen tomorrow. At some point the penny will drop and people will start investing. Perhaps we will get a shock interest rate rise and that will grease the wheels."

But the banking sector is by no means out of the woods yet. Although the fines and compensation bills are almost done with, the industry does seem adept at continuing to make large-scale blunders. Most recent among these was the TSB meltdown as it moved to a new IT system. Davies says:

"This is something we were concerned about with the Virgin and CYBG merger – we have gone through their plans for integration with a fine-tooth comb."

As well as that, banks' fortunes are intrinsically tied to the UK economy, the outlook for which is uncertain. Davies concedes that if the economy 'falls off a cliff' after Brexit, then the banks will 'almost certainly go south with it'.

While rising interest rates help to boost profits, they are increasing at a glacial pace, and this limits the amount banks can invest in their businesses.

Rising interest rates also bring new risks. UK households are overstretched and inflation could increase pressure on consumers, resulting in more defaults and hurting lenders in the process.

Davies says:

"The banking sector is that classic challenge of risk and reward: there is a reason why stocks are cheap, and we have to balance that and make a tactical judgment about whether the potential upside is worth that risk."

Three funds offering exposure to the sector

Jupiter UK Growth has 18% of its £1.3 billion of assets invested in the banking sector. Barclays and Lloyds are among its top 10 holdings, and manager Steve Davies also invests in Virgin Money.

Liontrust UK Macro Equity Income has around 9% of its portfolio in banks, with HSBC among its top 10 holdings, accounting for 5.6% of assets. Manager Jamie Clark also backs Close Brothers and Virgin Money.

JO Hambro UK Equity Income has almost 16% of its £3.8 billion of assets in the banking sector. Three UK banks – HSBC, Lloyds and Barclays – feature in its top 10 holdings, accounting for 14.3% of the portfolio between them. Manager Clive Beagles says in the most recent factsheet: "The banking sector is in clear dividend growth territory."

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