High Street banks out of favour with income share and fund investors, but is it time to reassess?

29th July 2014

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The number of direct investors holding high street bank shares has fallen by up to 54% says The Share Centre’s investment research analyst Graham Spooner.

Investors favour HSBC and Standard Chartered to gain exposure to banks moving out of RBS, Lloyds and Barclays.

Hargreaves Lansdown says it has spotted a big shift from income managers holding the banks though recovery style funds have often moved in to take up some of that investment.

Hargreaves says just 17% of active UK fund managers now hold RBS in their portfolios, compared to 55% in December 2006, according to its fund database shows.

This has been accompanied by a shift in the type of fund manager investing in the stock- equity income investors have been driven out by the absence of a dividend since 2008.

Laith Khalaf, Senior Analyst, Hargreaves Lansdown says: “Before the financial crisis it would have been a sizeable active decision to omit RBS from a UK portfolio, but now the bank is the sort of unloved stock preferred by contrarian managers searching for recovery plays. These types of fund can make strong returns for investors, as evidenced by the rise in the RBS share price on Friday. However they can require patience, and do tend to be more volatile because the stocks they invest in naturally have an element of uncertainty, and have to overcome negative market sentiment.”

Spooner, investment research analyst at The Share Centre, says: “Investors who have held onto the banks hoping for a recovery have seen some reward over the last two years. However, we have long warned there is no quick fix for the sector and it has run into troubled water again recently after showing signs of recovery. We believe the short term turbulence is likely to continue with pressures from rules and regulations, strain on costs and margins, lawsuits and provisions, restructuring plans, bad debts and competition.

Spooner adds that investors have seen any recovery in banking stocks as an opportunity to sell. He adds: “It appears more investors have seen any recovery in the traditional banks as an opportunity to sell. Perhaps locking in some of the gains made in 2013, rather than believing this upward trend would continue. The number of investors holding Barclays over the last two years has fallen by 9%, whilst peers Lloyds and Royal Bank of Scotland have seen a decline of 12% and 29% respectively.”

“There does however remain an appetite among investors for the sector and it has been the more diversified banks, HSBC and Standard Chartered, which have been the more popular picks. Standard Chartered has seen a 22% increase in the number of investors holding the share in the last two years and HSBC’s popularity is up 54%. The sector, once a favourite for income seekers, has seen much of the dividend flow taken away, however these players have continued to pay a decent yield. There is now evidence of the high street banks returning to the dividend list.

Spooner has also outlined his views on the UK banks.

Barclays (HOLD)

Barclays’ strategic review involving more job cuts and placing more importance in the future on its commercial and retail operations has been seen as ambitious. However, investors will be pleased to hear costs should be significantly lower by 2016. We continue to recommend Barclays as a ‘hold’. The bank has underperformed significantly recently and has suffered more than its peers. If Barclays can negotiate the choppy waters it finds itself in it could offer investors some long term value. The promise of increased dividends in the future is something for long suffering investors to focus on.

Lloyds (HOLD)

Analysts continue to highlight the pressure on earnings in the medium term. However there have been some signs of improvements in recent updates and its long term restructuring plans appear to be happening faster than expected. Improved confidence in the UK housing market should also benefit the bank. Investors will be pleased to hear Lloyds will start paying a dividend again in the second half of the year and hopes to increase dividends into 2015. The shares were the best performing in the FTSE 100 in 2012 and one of the top risers in 2013. We believe the reoccurring uncertainty in the sector could limit further upside so recommend investors ‘hold’ for now.

Royal Bank of Scotland (under review in light of results on 25 July)

Management continue to make progress with long term recovery plans and the slimming down of the balance sheet. Recent results showed the bank benefit from an improving UK economy and surprised the market with a stronger first half than expected. There has been improving trends in margins, costs and bad debt charges. We have previously recommended investors avoid the stock as there are better opportunities in the sector and market. However, following the results and the bank reporting the highest pre-tax profits since 2008, we have placed the stock under review.

HSBC (BUY)

Updates from HSBC the bank this year have raised doubts over its targeted return on equity and done little to help the shares establish a support level. However, HSBC has remained a significant dividend payer and though progress may be slow, the shares could be a better option than other banks at current levels. The bank is viewed as being more conservatively managed with a superior balance sheet and deposits. We recommend HSBC as a ‘buy’ for income seekers as it aims for a progressive dividend policy. Whilst growth in the short to medium term is likely to be limited we suggest investors take advantage of the weakness in the share price and build a holding over the longer term by drip feeding into the stock.

Standard Chartered (HOLD)

The share price underperformed last year and has continued to struggle as concerns grow on the performance of emerging markets. This has led the group to lower its revenue growth targets and could also put pressure on the dividend. This is a bank that had avoided many of the pitfalls made by most of its peers. However, we recommend investors ‘hold’ for now due to rumours of unrest by institutional shareholders with regard to management performance. The company’s exposure to emerging markets makes it a geared play on any upturn in the economic situation. However, the general slowdown in Asian economies means the bank will not return to double digit earnings growth over the next two years

Hargreaves’ Laith Khalaf has also provided the following assessment of recovery funds holding one previously troubled UK banking stock RBS.

He says: “At its peak in December 2006, RBS made up 3.37% of the FTSE All-Share and our analysis shows 55% of UK managers held the stock. Now, the stock makes up just 0.34% of the index, and just 17% of UK managers hold the stock.”

The contrarian funds that hold RBS

Here are 5 of the funds with the biggest exposure to the bank:

Schroder Recovery – 4.3% invested in RBS.

Schroder Income – 3% invested in RBS.

Nick Kirrage and Kevin Murphy manage both these funds- they are deep value investors looking for stocks which have underperformed but which they believe can stage a recovery.

Nick Kirrage, fund manager, Schroder Recovery and Schroder Income says: ‘Bad headlines can sometimes produce good opportunities, and nowhere have headlines been worse than banking. However, after several years of de-risking and simplifying, today’s low bank valuations represent an attractive opportunity, particularly for income investors, as business profits improve and dividends re-emerge. Uncertainties remain, but seven years on from Northern Rock, UK domestic banks are in much better shape to weather any challenges ahead and finally generate meaningful returns for their shareholders.’

Investec UK Special Situations – manager Alistair Mundy has 3% invested in RBS.

Alistair Mundy specifically looks for companies which have had a torrid time and have seen their share price falling.  He looks for companies which have too much debt, or cyclical or structural challenges, but typically won’t invest in a company which faces more than one of these three headwinds. Mundy also runs the well-known Investec Cautious Managed fund in similarly contrarian spirit.

Alistair Mundy, fund manager, Investec Special Situations says:”We believe that Royal Bank of Scotland retains some very strong operating businesses which have been overlooked by both management and investors for a number of years as restructuring took centre stage. As the RBS clean-up continues, we think the prospects for the core businesses to grow and be better appreciated could drive the share price further.”

Jupiter UK Growth- manager Ian McVeigh has 3.4% invested in RBS. This fund sits on out Wealth 150 list of favourite funds.

Jupiter Undervalued Assets-  manager Steve Davies has 3.5% invested in RBS.

Managers Ian McVeigh and co-manager Steve Davies are naturally contrarian, seeking to take advantage of opportunities other investors may have overlooked. They look for stocks which fall into one of the following buckets; sustainable growth opportunities, unloved stocks with low valuations or turnaround situations (recovery stocks). The fund remains significantly exposed to the banking sector, and one of the main themes at present is to capitalise on the rising wealth of emerging markets through companies with strong global brands.

Other recovery funds

We like the following recovery funds and would suggest them for investors’ consideration:

M&G Recovery, managed by Tom Dobell. The fund has historically performed well in a variety of market conditions but more recently has experienced an uncharacteristically poor period of performance. This can be attributed to stock specific disappointments, particularly in the resources and oil & gas sectors, with companies such as Kenmare Resources experiencing delays in planned increases to production.

However, periods of underperformance are part and parcel of investing in recovery situations. Tom Dobell remains in close contact with these companies and continues to see recovery potential, believing the issues are temporary. While recent performance has been disappointing, we focus on the longer-term and retain faith in the fund manager’s ability.

Fidelity Special Situations managed by Alex Wright. The manager adopts a contrarian approach. His focus is on identifying unloved and undervalued companies where the market has overlooked the potential for growth or positive change. He looks for two main characteristics in any company he invests in – downside protection (for example in the form of a strong balance sheet, good cash flows, barriers to entry and low valuation), and unrecognised growth potential.

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