I can’t invest directly in bank shares. The reasons are very simple: I don’t know what I am buying a slice of – you only find out when loans have gone bad after the event – and I think banks are very unimpressive businesses. Their modest returns on equity can only be achieved by taking on lots of debt.
On the face of things, banking is quite simple. The profits and returns to shareholders of a bank are based on a few key drivers:
- The difference between the interest paid to savers and the interest received from borrowers – the net interest margins.
- Income such as fees from selling other financial products.
- The costs of running the bank.
- The amount of debt compared with shareholders’ equity.
Lloyds (LLOY) has had a fairly reasonable 2018. Net interest income increased by 3 per cent with costs flat, leading to an increase in underlying profit of 6 per cent. The underlying return on tangible equity looks pretty decent at 15.5 per cent.
In my opinion, safe banks finance themselves with customer deposits, but Lloyds is still reliant on some wholesale finance with a loans-to-deposit ratio of 107 per cent. I’ve never put too much faith in tier one ratios, which give assets a risk weighting. I prefer to keep things simple and just look at what amount of equity is supporting the bank’s assets.
Lloyds’ assets are 16.6 times the amount of equity it has. Put another way, it is financed like having a house with a 94 per cent mortgage. If you base your measure of gearing on tangible equity then the gearing ratio is 21.1 times. That may be better than in the bad days before the financial crisis, but it is still very high. To put this into perspective. Lloyds’ return on assets is a meagre 0.73 per cent – what’s good about that?
Despite my downbeat assessment, investors cheered the results, which saw a 5 per cent increase in the dividend payout and a bigger-than-expected share buyback.
The 5.4 per cent forecast yield has some attractions and looks safe as long as the UK economy remains stable, but I think investors can get better results putting their money behind better businesses.
Alpha subscribers can read the rest of Phil's weekly shares round-up here.
