Equity markets are made up of stories and numbers. We can get carried away by exciting stories, such as the potential of robotaxis and the emergence of obesity medicines. Numbers — such as the ratio of a share price to a company’s earnings and its profit margins — may seem dull in comparison.
For someone buying shares, though, both are important. Stories can give companies powerful momentum; numbers highlight opportunity.
Look at current numbers on European equities — including the UK — and your investment antennae might start to twitch. The historical price-to-earnings ratio of European equities looks attractive at around 18x on average. The S&P 500’s in the US, by comparison, is more like 26x — historically high.
Most of this regional difference is explained by the US being awash with technology companies that have exciting stories. European markets, by comparison, have many more financial stocks. These look relatively dull on the bedtime story front, but might their numbers indicate exciting investment potential?
Shares in the US’s biggest bank, JPMorgan (price/earnings ratio 13x), have risen by more than 50 per cent in the past year, leaving popular shares such as Microsoft in their wake — pretty much flat.
Most European banks trade at between 7x and 9x their earnings. And they, too, have also performed well. Barclays shares have more than doubled; France’s Société Générale’s are up 65 per cent; and shares in Spain’s Banco Santander have risen 48 per cent.
Their earnings multiples can look very juicy indeed compared with those of the wider market. But be careful. Banks are not like other companies, and investing in bank shares is not for the faint-hearted.
Nobody should want banks to grow faster or slower than an economy in the long run. Banks have a role to fulfil — keeping our deposits safe and lending money to those that need it, especially housebuyers and smaller businesses.
Banks’ earnings are generally the difference between two very large numbers: the deposits they hold and the loans they have made. Bankers spend a lot of time thinking about numbers. For instance, they notice that 2025 is a perfect square: 45 times 45. It is also the sum of the first nine cubes — one cubed plus two cubed . . . up to nine cubed. Bankers love that sort of thing. The fact that I do too may explain the paucity of dinner invites I receive.
When interest rates rise, as they did recently, banks benefit because they can get away with a bigger margin between what they pay in interest and what they charge. So the earnings of many banks have risen sharply since the beginning of 2022, when central banks started lifting base rates.
Last week, Société Générale announced that profits had doubled in the fourth quarter of 2024. Shares jumped 10 per cent in a day on the news.
However, these earnings bonanza periods can be fleeting — interest rates can fall, and the people you lend to can fail to pay it back. Banks do not enjoy recessions. If your lending rate is only a percentage point or two higher than you pay on deposits, it only takes a few borrowers to go bust and all your profits are eaten up. Suddenly you are making a loss.
As the earnings of banks therefore rise and fall much more dramatically than most, we need to be more conservative in valuing them. We need a valuation tool that represents the relatively stable nature of a bank outside financial crises. The number most financial analysts start with is “book value” or “shareholders’ funds”. This represents the past profits of the bank which have been retained and which belong to shareholders.
Taking Lloyds Bank as an example, its book value can be found in its report and accounts — £47bn. Divided by the billions of shares in issue, that gives 74 pence of book value per share, and the current share price is 63 pence. Buying a bank share is always risky, but the risks are much lower when the shares are below book value. In 2007, many UK bank shares traded far above.
After the global financial crisis, regulators forced banks to hold much bigger reserves. It means they are sitting on great piles of money that cannot be lent out. Relaxing those requirements and allowing banks to lend more (or give more back to shareholders) is becoming an increasingly attractive option for politicians desperate to spur growth.
Lower capital requirements could make banks look much better investments for equity holders. So, even though the shares have re-rated significantly in the past year, it is not necessarily too late to buy.
If selecting a bank to invest in, you should consider a range of factors. Does it operate in an economy with steady-to-improving economic prospects? Does it have a high market share so it can lead on setting lending rates? Do its shares trade below book value and does its profitability have scope to rise? Is it run by steady individuals who avoid taking risks in lending and trading? Is there a financial crisis around the corner? Refinancing a bank in a crisis effectively asks shareholders to give back all the dividends they have received and more.
For readers who think the UK will enjoy improving growth and believe the UK housing market is stable, Lloyds Bank has a dominant franchise. Hopefully, litigation regarding car loans mis-selling can be resolved, as that issue hangs over the shares. Similarly, readers who believe the continental European economy will improve might invest in France’s BNP Paribas shares or Banco Santander, which has strong positions in Spain and Latin America.
A massive UK company that has not been discussed much on investment hotlines for years is HSBC. Its shares also trade at a 20 per cent discount to book value, have a dividend yield of 5.5 per cent and have exposure to economic recovery in the UK, Europe and China.
The new management team seems determined to simplify its very complex structure, which may lead to the European and Hong Kong businesses eventually being split — which could drive the shares higher.
In short, then, banks may not be the most exciting story, but at this point in the economic cycle — when debt looks manageable and economies are at least stable — the numbers are interesting. Take your pick. Just do not “buy and forget”. Owning bank shares is like picking up pound coins in front of a steamroller — fun until you are flattened.
Simon Edelsten is a fund manager at Goshawk Asset Management
