British banks beat stress tests: time to invest?


Updated on 28 October 2014 | 1 Comment

British bank shares fell, despite beating European stress tests. With sterner tests still to come, will they soon represent a bargain investment?

25 European banks failed the latest bout of 'stress testing' from the European Central Bank (ECB). The ECB conducts these tests periodically to ensure that, in the event that the euro-zone economy were to deteriorate substantially, key banks would not need to strengthen their balance sheets with taxpayer-funded bailouts.

In total 130 banks were subjected to the testing. Of these 25 failers, nine were in Italy, the worst of which was Monte dei Paschi di Siena (MPS), the oldest bank in the world and Italy's third-largest bank. However, all of the British banks passed.

These results were a little worse than expected, so European investors responded by marking share prices lower. Here in the UK, bank shares fell modestly, with share prices of the UK's big four banks down as follows at Monday's market close:

Bank

Share-price

change

Lloyds Banking Group

-2.1%

Barclays

-2.0%

Royal Bank of Scotland

-1.4%

HSBC Holdings

-1.2%

Prices as at market close on Monday 27th October

As you can see, Lloyds shares were the biggest faller on Monday, dropping over 2% on news that it only just cleared the ECB's stress testing. As the UK's biggest mortgage lender, Lloyds was hit hardest by the 15% fall in house prices embedded within the ECB's test variables. However, HSBC - regarded as one of the best-capitalised banks in the world - saw its share price decline by a mere 1.2%.

These falls are very modest compared to those experienced by European banks that failed stress testing. At one point, MPS shares crashed by almost 22%.

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Stricter testing to come

However, stress testing is far from over for UK banks.

[SPOTLIGHT]On Tuesday 16th December, the results of stricter bank stress testing by UK regulators will be released. These tests will be considerably tougher than the ECB's, reflecting concern that property prices in the UK have soared much faster than in other major economies. In this follow-up test, UK banks' balance sheets will be battered by a simulated 30% plunge in house prices, rather than the 15% fall used by the ECB.

Clearly, were UK house prices to fall by nearly a third, the financial health of British banks would take a beating, which is why some analysts have already downgraded their recommendations for UK bank shares.

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Which bank should you buy on falls?

Given that UK banks could face a reputational setback come mid-December, their share prices are likely to stay under a cloud until these additional stress test results are released. In the meantime, let's take a look at the relative merits of the big banks' shares, to see if any stand out in value terms (table sorted alphabetically):

Bank

Share

price (p)

Price/earnings ratio

Dividend

yield

Dividend

cover

Price/book

ratio

Barclays

221.85

11.0

2.9%

3.1

0.6

HSBC Holdings

622

11.6

5.1%

1.7

1.0

Lloyds Banking Group

75.34

10.0

1.5%

6.6

1.4

Royal Bank of Scotland

359.2

11.4

0.0%

N/A

0.4

Prices as at market close on Monday 27th October; data from Digital Look

All of this data, bar current share prices and price/book ratios, are forecast figures and therefore subject to change. For example, Lloyds and RBS pay no dividends right now, but analysts expect Lloyds to resume these regular cash payouts to shareholders in 2015.

Based on their respective forward price/earnings ratios (PERs), not one of these bank shares looks particularly cheap to me, as all trade on PERs of between 10 (Lloyds) and 11.6 (HSBC).

However, were bank share prices to decline by, say, 10% to 20% after December's stress testing, then British banks will drop down into bargain territory. For example, a 20% decline in Lloyds share price would put it on a PER of just eight, which is comfortably into value territory in historical terms.

Then again, for income-seeking investors, HSBC stands head and shoulders above its mega-bank rivals. With its current dividend yield of 4.9% expected to rise to 5.1% in 2015, HSBC is the only big UK bank to offer juicy dividends to investors looking to income ahead of capital gains. That said, HSBC's dividend is covered only 1.7 times by its earnings, which is a little low for comfort.

Lastly, looking at price/book ratios (where a bank's share price is divided by its book asset value per share), RBS is far and away the cheapest. The Scottish bank has a PBR of just 0.4, versus 1.4 at Lloyds. A low PBR may lure deep-value investors, but it could also be an indicator of poor asset quality at RBS.

What do you think? Are you putting your money into banks? Let us know your thoughts in the comments box below

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Beginner's guide to buying and selling shares

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