Trading Bank Shares

By: Daniel Jones
Share prices react to news and information, but price alone is not always an accurate reflection of a company’s value in the short-term. Information gaps, market sentiment and rumours can cause the price to deviate from a company’s intrinsic value. In the long term, share price and value should align, at least in theory.

Value is a direct function of risk and return. Market participants have a different risk/return profile, which means that a company’s equity may not be attractive to everyone at certain price levels. In a downturn, however, strong support may start to appear as the risk/return trade-off of a particular security or sector starts to appeal to a greater number of investors.
Therefore, identifying a period of strong fundamental support may help traders identify the bottom of a cycle.

One way of looking at support is by identifying fundamental ratios and comparing them with the previous 2000-2002 banking sector downturn. Two key ratios are Price to Earnings (P/E) and Price to Book (P/B).

The P/E multiple compares a bank’s share price with its latest annual earnings per share.

The P/B multiple compares a company’s share price with its book value of equity, also referred to as ‘shareholders funds’ (total assets less total liabilities).

Looking at the lowest P/E and P/B ratios of the 2000-2002 banking sector downturn, most of the FTSE 100 banks are already trading at lower P/E and P/B multiples than in the previous downturn.

The fact that most of the banks are trading below comparable multiples shows an absence of fundamental support levels and indicates that investors are not giving as much weight to these multiples as they did in the past. That is possibly because the market has been reacting negatively to any news concerning writedowns and a slowdown in the economy.

Investors may also be discounting these multiples on the basis that the systematic (sector wide) and unsystematic (company specific) risks inherent to this banking sector downturn are unique and much greater than the risks in previous downturns.

The latest credit market blowout and the introduction of securitised leveraged products have made it a more dangerous playground as the risks present in this downturn have become harder to quantify. Liquidity constraints in the secondary market have raised doubts or concerns on a number of issues including the alternative valuation methods used to price complex securitised products, the level of write-offs incurred so far and the possibility of future write-downs. In turn, this has also tainted the accuracy of future earnings forecasts. All these factors may help explain why we are entering a period where P/E and P/B multiples are at historic lows. Therefore, an absence of a fundamental support and the likelihood of increased systematic and unsystematic risks occurring as a result of a more pronounced downturn in the UK housing market, leads me to believe that the sector has not reached a bottom yet.

Balance sheet restructuring and risk management are among the most important functions for a bank at this juncture. As a result, I believe that cost controls, the sale of non-core assets, a bank’s ability to attract funds and a reduction in the exposure of certain asset backed securities will all play an important role in helping liquidity and will be key issues going forward.

So should we be buying banking shares and spread bet on stocks to increase? What do the professional think? Anthony Grech, Analyst, IG Index, said in his 2008 Banking Report that he believed that “those banks that successfully manage to survive this downturn will ultimately prove to be excellent investment opportunities within the next 5 years. Speculators interested in the sector’s upside prospects could start to allocate very small amounts of their wealth during dips. However, I must caution that I also believe that further sub-prime news and economic deterioration in the UK and US will drag on the sector and that better entry levels could be achieved at a later stage”.

Spread betting carries a high level of risk to your funds. You can lose more than you initially invest. It may not suit all investors. Only speculate with funds that you can afford to lose. Ensure you understand the risks and seek independent financial advice if and when necessary.