Are UK banks cheap stocks and is it safe to buy them?

A brochure showing some of Lloyds Banking Group's major brands

Ever since the financial crisis of 2007/08, I’ve pondered the question of whether UK banks are cheap stocks and a safe investment for me. A couple of years ago, I was beginning to think they were.

Their balance sheets had been repaired, and fines and compensation payments had dropped away. They’d begun making healthy profits and paying dividends, despite the unhelpful backdrop of record low interest rates. Then Covid-19 came along.

Looking from an investing perspective today, I see it as positive that banks safely managed last year’s turmoil, and yet can be bought at prices well below their pre-pandemic levels.

Cheap stocks?

Price-to-book (P/B) is a traditional way to value bank stocks. A P/B of below 1 indicates the stock is trading at a discount to its net asset (‘book’) value. This suggests the stock is cheap, provided the balance sheet accurately reflects the true value of the assets (loans) and liabilities (deposits).

Currently, the five FTSE 100 banks — Barclays, HSBC, Lloyds, NatWest, and Standard Chartered — are trading at P/Bs of well below 1. Given the dampener put on their shares by their long post-financial-crisis rebuilds and the recent pandemic, perhaps I should look back to more normal times for clues to their future valuations.

Historical valuations

Before the financial crisis, bank stocks traded at multiples of their assets. They sported P/Bs of two, three, or even higher, compared with today’s nought-point-somethings.

However, banks were making much higher returns on equity (ROE) in those days. They were doing it by juicing their returns on assets (ROA) with very high levels of financial leverage. For example, according to my old notes, Lloyds earned an ROA of 0.9% in 2007, but with average financial leverage for the year of 29.1 times, produced an ROE of 28.2%.

The great Warren Buffett thought these kinds of numbers were crazy. It was an example of what he’s called “the tendency of executives to mindlessly imitate the behaviour of their peers, no matter how foolish it may be to do so.”The outcome? To borrow from Buffett again, when the “tide went out” in 2007/08, everyone could see the bankers had been “swimming naked.”

Not only cheap, but also safer stocks?

Today, banks are employing much lower financial leverage. For example, over the last 12 months, Lloyds used average leverage of 17 times, turning an ROA of 0.54% into an ROE of 9.4%. All the UK’s big banks have sustainable ROE targets in the 10%-15% region — far lower than of old.

I think these kinds of ROEs merit P/Bs in the 1-1.5 range. On this basis, I view the FTSE 100 banks, at sub-1 P/Bs, as cheap stocks. And due to bankers’ more cautious mindsets and use of lower leverage — as well as mandatory capital buffers and close regulatory oversight — I also think banks are safer than in the past.

This is not to say an investment in banks wouldn’t suffer in the event of an economic downturn or full-on recession. Lenders’ fortunes, and the value of their assets and liabilities, are highly sensitive to the performance of the wider economy. I cannot invest in banks without taking this risk onboard.

However, because I can currently pick up their assets at discount prices, I’d be happy to buy Barclays, HSBC, Lloyds, NatWest, and Standard Chartered today.

The post Are UK banks cheap stocks and is it safe to buy them? appeared first on The Motley Fool UK.

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G A Chester has no position in any of the shares mentioned. The Motley Fool UK has recommended Barclays, HSBC Holdings, Lloyds Banking Group, and Standard Chartered. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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