With the global financial crisis firmly behind us, the banking sector presents a superb opportunity to buy companies that are delivering improved financial performance, and yet which trade on relatively appealing valuations. Of course, two banks that fall into this category are part-nationalised Lloyds (LSE: LLOY) (NYSE: LYG.US) and RBS (LSE: RBS) (NYSE: RBS.US), which have both returned to profitability in recent years following a hugely challenging period.
Clearly, they are not back to full health just yet, but are both well on their way. As such, the government is planning on reducing its stakes in both banks, with its Lloyds share rapidly falling and set to reach zero over the short to medium term. Meanwhile, it has been rumoured that the government will seek to offload around 50% of its shares in RBS within two years.
Of course, major share sales such as these are likely to dampen investor sentiment in the short run, since it means that there will be an increase in supply of shares in both banks and, unless demand increases in-line with this rising supply, Lloyds and RBS may disappoint in terms of share price performance in the short run.
However, over the medium to long term, the sale of the government’s stake in the two banks is likely to lead to improving investor sentiment. After all, the government is only a shareholder out of necessity rather than choice, so the fact that it is no longer needed indicates to investors that both Lloyds and RBS are becoming increasingly healthy and financially sound. Evidence of this can be seen in their forecasts, with both banks set to post exceptionally high levels of profitability in the current year. For example, Lloyds is set to have a pretax profit of £7.8bn, while RBS’s pretax profit is due to rise from £980m this year to around £2.7bn next year.
Despite this, both banks trade on very appealing valuations, with Lloyds having a price to earnings (P/E) ratio of 10.6 and RBS’s P/E ratio being a still very appealing 13.3. As such, now appears to be a great time to buy ahead of the potential for improved investor sentiment which could lead to a significant upward rerating of both stocks.
Meanwhile, further evidence of their financial strength and the improving confidence that their management teams have in their futures can be seen in their expected dividend payouts. Lloyds, for example, is expected to increase dividends per share by 50% in 2016, while for RBS the figure is even higher, with dividends per share set to be 3.3 times greater in 2016 than in the current year. Such strong dividend growth puts Lloyds on a forward yield of 4.7% and RBS on a forward yield of 1.5%, with further dividend growth potential being very likely over the medium term.
As a result of their low valuations, strong dividend growth prospects and, crucially, the scope for much improved investor sentiment resulting from the government’s planned share sales, Lloyds and RBS appear to be excellent investments at the present time.