Talk to any foreign fund manager and they’ll raise their eyes at the stocks prices for Australian banks. A housing bubble waiting to pop, they’ll tell you, and you’re paying three times book value! Wells Fargo, one of the US’s best run and most profitable banks, trades at 1.4 times book and the US housing market has already corrected.
I have some sympathy for the argument. Most Australians don’t realise how risky their bank shares are. But I also think many foreigners don’t understand how much a big four banking franchise is worth. It was already a concentrated sector. Then the financial crisis came along and the fifth and sixth largest banks in the country were swallowed up by two of the big four. Now it is absurdly concentrated. The Aussie banks will have their problems over the next decade, but on average their dominant positions should result in well above-average returns on shareholders’ capital.
Which got me thinking. Instead of worrying about how overpriced the Australian banks are relative to their foreign compatriots, how about we find some foreigners that are cheap relative to the Australians. Surely the financial crisis had a similar impact elsewhere – where else have we seen a significant increase in market dominance over the past five year?
Step forward the United Kingdom. A 2010 Government report into competition in the UK banking system laments the current state of affairs:
The financial crisis has resulted in significant consolidation of the UK retail market. Well known firms such as HBOS, Alliance & Leicester and Bradford and Bingley have either exited the market or merged with rival firms. A large number of building societies have merged, undermining the diversity of provision in the sector. Whilst these ‘rescues’ were necessary in order to preserve financial stability, the consequence has been to reduce competition and choice in the market.
The politicians are rightly worried about the impact on UK consumers. But I am wondering what the consequences are for long-term bank profitability? Why can’t Lloyds TSB be as profitable as CBA given its dominant market share? The five largest providers – Lloyds TSB, RBS, HSBC, Barclays and Santander – have 88% of transaction accounts in the UK. They provide 75% of new mortgages, 60% of personal loans and 80% of finance to the Small and Medium Enterprise sector. That’s almost as good (or bad, depending on your perspective) as Australia, and surely sets the scene for juicy profits.
Lloyds is the largest of the big five and has the biggest market share in all three categories above (although this will be reduced if European-regulator enforced disposals proceed later this year). It also has a significant wealth management business and limited investment banking operations. It’s a clean play on the UK retail and commercial banking sector and, best of all, it trades at 0.9 times tangible book value, less than one third the price of CBA.
So far, so good.
The part that worries me, though, is the current state of the balance sheet. More than half of Lloyds’ assets are mortgage loans and the book doesn’t look pretty. Here’s a table from the 2011 annual report:
Some 13% of retail mortgage loans are secured by properties that are worth less than the outstanding loan balance. More than 40% of the book has a loan-to-value ratio in excess of 80%.
Is that scary or am I just a fearful child of the financial crisis?
Given the current state of the UK economy, it’s not hard to imagine a large hole blown in Lloyds £46bn of shareholders’ equity. I’m willing to bet the UK banking sector will be earning outsized returns on capital by the time this decade ends. The only question is how much capital will be left.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.