The historic Brexit vote that took place last Thursday sent the market crashing. Although many stocks have partially recovered, those in the Banking sector have been hardly hit and have stayed down. The likes of Barclays (BARC), Lloyds Banking Group (LLOY) and Royal Bank of Scotland (RBS) are downing excess of 15%, whilst HSBC (HSBA) and Standard Chartered (STAN) have faired slight better. So this begs the question, are banking stocks cheap and should you buy them?
Whilst on paper banking stocks around Europe look cheap, I would not touch them with a proverbial barge pole. As an investor, I aim to invest in businesses that are simple to understand and which allow me to easily value its cash flows and its economic engine. Unfortunately, when it comes to the world of banking, the businesses in the sector are far too complex. Just looking at the balance sheets with all the derivatives gives me a headache – it is almost impossible to gauge a bank’s exposure to bad debts, currencies and interest in. And if a business is far too hard to understand, the best option is to keep away.
Two of my favourite fund managers, Terri Smith and Neil Woodford have this same adversity to banks. Go and look at their Fundmith Equity Income Fund and Woodford income fund to see how much exposure they have to the traditional banking sector, it is virtually none. And there is good reason for this. As Terri Smith says, banks are bad businesses to invest in is because they require substantial amounts of leverage in order to make an adequate return.
One of the underlying principles when it comes to my investment strategy is to never invest in a business which requires leverage or borrowing to make an adequate return on equity. Sure, some of the the companies I have invested in do have some borrowings, but the key factor is that they do not require it in order for them to survive. Furthermore, these businesses make a decent return before the use of debt, rather than making small returns on their assets and then financing most of those assets with debt.
On the other hand, banks are heavily reliant on leverage to a greater extent than any other business. A 5% Equity to Assets ratio for a bank is leverage of 19 in debt to 1 of equity. With such high levels of leverage, when something goes wrong, shareholder value drops to Zero really quickly. Just look at what happened during the financial crises! Although banks like Lloyds and Bank of America still exists, the shareholders got completely wiped out!
If you really delve into the accounts of a bank, the returns are not as much as they appear to be. Just look at what Terri Smith had to say when he wrote a piece for the Financial Times:
Most banks under the traditional banking model have a low returns of 1% or 2% on its total assets; but as 95% of the assets are funded by depositors and bondholders, the return on equity is much higher. A return of £1 on £100 of assets is a return of 20 per cent on the £5 of equity capital. This is all fine – until something goes wrong. Then a loss of just 5 % of the value of the assets means the shareholders’ equity is wiped out.
For me, banking stocks are just too risky to own and the companies themselves are too hard to understand. Sure they appear cheap at the moment and I am in no doubt that traders will make money from buying shares at the current lows, but as a long-term investor, I don’t want to put my money into an asset which can be wiped out at any moment.
From my own personal point of view, if I want to gain exposers to financials, I would rather buy into insurers, asset managers or financial proxy’s like Credit Card companies. I have been keeping an eye on the likes of Legal & General, Prudential and Aviva and once their stock prices get into my intrinsic value range, I will be placing buy orders. Another company whose stock I have been closely following is Visa. The company has a wonderful business as it operates as a toll booth of sorts in the financial transactions world. As the move to a more cashless world continues, Visa is only set to grow and make more profits over time. And the best part is, the company is virtually debt free!