Banks might ‘feel’ like sensible investments, especially when they trade on apparently low valuation multiples, such as now.
But do banks such as Barclays (LSE: BARC), Lloyds Banking Group (LSE: LLOY) and Royal Bank of Scotland Group (LSE: RBS) really offer a safe way to invest defensively in large caps?
No. I think banks are far from safe, even now after a long run of well-publicised problems that could lull me into believing that the worst is behind the banks.
But they are banks!
The expression “it’s money in the bank” is often taken to mean ‘rock-solid safe’ or similar. I’ve seen folks transfer that meaning to bank investments, which strikes me as a big mistake.
Perhaps banks tend to attract investors in that way because they deal in nothing but money. Banking businesses remain unencumbered by the operational risks that beset the activities of more complicated businesses.
However, banks have oodles of their own ongoing problems, many of which make banks uninvestable as buy-and-forget propositions. Banks are risky, and that’s not just now — it’s all the time. Just because banks have endured a series of recent challenges and setbacks doesn’t mean it’s safe to dive into bank shares now.
I reckon, when it comes to banks, we should bin that old saying ‘the safest place is the most dangerous place’. With the London-listed banks, the dangerous place remains the dangerous place. Maybe that’s why the big institutional investors don’t seem to be investing in Barclays, Lloyds and RBS much.
Here are the problems
Right now, the London-listed banks face increasing regulatory costs and burdens. The regulators appear to be aiming to reduce the influence that Britain’s big banks have on the nation’s business and personal finances in times of crisis, by insisting on stronger balance sheets and financial safety cushions. At the same time, the government encourages competition from newer players in the banking sector.
However, just as that all happens the banks seem to be shedding assets and narrowing their focus to concentrate on the UK banking market. This amounts to structural change in the banking sector. It looks like we’ll see more banks fighting over a smaller market, which doesn’t bode well for investment returns over the longer term.
That structural challenge isn’t the only problem, nor is it the biggest. I’m avoiding the banks because they are some of the most cyclical beasts trading on the stock market. That means the banks are not as cheap as we might think, and a big risk lies ahead.
Banks ‘should’ be cheap
We tend to see banks and other cyclicals trade at ever falling valuation multiples just as profits rise through an unfolding macro-economic cycle. So, price-to-earnings ratings fall and dividend yields rise. I think that effect will drag on total investor returns from here. On top of that, there’s likely to be a trapdoor for investors to fall through down the road. When the macro-cycle next turns down, banks profits will likely follow and their share prices will probably plunge — a situation that could take back years’ worth of dividend gains.
Banks such as Barclays, Lloyds Banking Group and Royal Bank of Scotland strike me as among the most risky of potential stock market investments now, which is why I’m resisting the temptation to buy their shares despite ostensibly cheap valuations.