Yahoo Finance Terry Smith never invests in banks, but Warren Buffett has billions in them. Who’s right?
Jumps of around 10pc in the share prices of NatWest and Barclays this past week grated with me, as if I am knowingly missing out. At 230p and 162p respectively at the time of writing, they still offer yields of 7pc and 6pc, with decent earnings cover.
For such well-established businesses, this continues to look cheap – unless there is some flaw in their set-up.
Maybe enough of us remain viscerally wary of banks since the 2008 crisis. I was exposed to commodity-related shares but held no financials and got lucky when oil and coal prices later soared and led to takeovers. But I had vicarious experience through a late friend who was scarred by permanent seven-figure losses from banks.
After a large early stake in Northern Rock “10-bagged”, it turned into a write-off; he was also heavily exposed to Lloyds and HBOS. Many people had a rude shock, having got used to banks’ dividends supporting an affluent retirement.
Yet the excesses leading to the 2008 crisis were quite exceptional and since then banks and their regulators have toughened up substantially. Costs continue to be taken out; Barclays declared a target of £2bn over the next three years, for example.
Which guru to believe on banks?
Terry Smith has to be answered satisfactorily. The former top-rated bank analyst, who later founded Fundsmith, a £24bn asset manager, has emphatically declared he would never invest in them.
Balance sheets are too leveraged, which means their equity (also known as net assets or shareholders’ funds) is very small relative to assets and liabilities supported.
If a recession causes, say, 10pc of loans to sour, it would prompt a run on the bank and (possibly more than) obliterate equity value. Shareholders, in other words, would lose everything.
Yet NatWest has just declared net impairments or bad loans of £578m for 2023 – just 0.15pc of customer loans – even though Britain was technically in recession in the second half of last year. It may have been a mild one, but this statistic implies discipline around lending.
Warren Buffett sees logic for big positions: Bank of America is Berkshire Hathaway’s second-largest holding at around $30bn and American Express is his third-largest at around $26bn.
While Buffett negotiated in 1994 a rather cute “preferred stock” investment in Amex with warrants, which returned 64pc over three years, Berkshire has kept raising its stake during the past decade. Perhaps we should consider if this reflects the quality of US banking management, as Buffett has not bought into British banks even though valuations are markedly cheaper.
Both of his banks’ long-term charts show better performance relative to major British lenders, especially since the 2008 crisis.
Banks are a tricky call
Only a month ago, the insolvency specialist Begbies Traynor reported a sharp rise in critical financial distress in Britain over the last quarter of 2023: more than 47,000 businesses were near collapse, it said. While a third of those in trouble relate to construction and property, all sectors were said to be hurting.
That would appear to imply weaker demand for credit and an increased prospect of bad debts, even if the Bank of England is sensitive enough on interest rates not to trigger a lot of mortgage repossessions.
Yet its Governor has this week shifted his narrative to say Britain’s “very small” recession may already be over, hinting that the Bank may cut interest rates sooner, as inflation does not need to reach its 2pc target beforehand.
Meanwhile, in the US – ironically, given its recent strong economic numbers – came news that bad commercial real estate loans had overtaken loss reserves at the biggest banks after a sharp increase in late payments linked to offices, shopping centres and the like.
Shares in most big American lenders shrugged this off, however, despite a sell-off in the shares of regional US banks over recent weeks, if not to the extent of March 2023 when Silicon Valley Bank went under.
Yet German banks have started to provision for US property loans, and one of the smaller ones has described the US market as “the greatest real estate crisis since the financial crisis”. I would certainly keep an eye on it.
In theory, a good buy as the cycle turns
Two declared possible cash offers for Currys, the electricals retailer, one from America and the other from China, support my sense that the British economy could be at about its low point. That is the time to grab listed companies when investor sentiment is still jaundiced.
Yes, if interest rates fall this could help consumer spending and therefore demand for credit, but it would also reduce banks’ “net interest margin” – the difference between interest paid on deposits and received from loans. This seems in essence why NatWest proclaimed “a 20pc rise in operating profits in an exceptional macroeconomic environment”.
But nothing similar for Barclays, whose profits were only 2.5pc ahead. Return on equity, a key measure of profitability, rose from 12.3pc to 17.8pc for NatWest but at Barclays it slipped from 11.6pc to 10.6pc even “excluding structural cost actions”.
It seems that the drag for Barclays remains its more volatile investment banking operations. It is not easy to assess them because the bank lumps them together with “corporate banking”; together they account for half of group revenues.
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Such a proportion is large by European standards but average for America and I cannot have much sympathy for Barclays when the likes of JP Morgan run diverse operations satisfactorily.
It’s true that American shares tend to enjoy a premium to those listed here, but Goldman Sachs sustains an earnings multiple in the high teens as a premier investment bank. Barclays’ own multiple is about six.
Will banks’ big discounts to asset value unwind over time?
Barclays still intrigues me because its tangible net asset value of 331p per share represents a 51pc discount in the share price at the time of writing, while NatWest’s 292p per share NAV implies a 21pc discount.
Capable management should be able to narrow that gap although Barclays’ strategic plan seems chiefly to be to expand the other divisions so that investment banking shrinks modestly by comparison.
The jump in the shares probably came in response to Barclays’ plan to return at least £10bn over the next three years (albeit principally via reducing the share count while keeping the total sum spent on dividends stable). This would be a colossal return relative to Barclays’ £24.5bn market value.
Raising revenues from £25.4bn to £30bn by 2026 seems a very bold target, significantly contingent on the economy.
As in previous years, Barclays is intriguing if hardly satisfying as a “conviction” share, despite its contrarian appeal versus the likes of NatWest. Perhaps I should not over-fuss and recognise that the discount to asset value should narrow at least to some extent.
The discount at Lloyds is only 14pc, based on a 43.5p market price and the bank’s 50.8p in net tangible assets per share at the end of 2023, declared with last Thursday’s results.
Underlying profits managed an 11pc advance, which was good, but what if the net interest margin contracts?
Lloyds says it is confident enough in its strategy, however, to maintain even its 2026 guidance – despite a regulatory inquiry into car financing, for which a £450m provision is already established.
I would not disagree with patient holders of UK bank shares, but if only the investment case were more clear-cut.
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