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11th February 2015

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Steve Davies, co-manager of the Elite Rated Jupiter UK Growth

The co-manager of Elite Rated Jupiter UK Growth fund, believes that some UK banks could be in a position to deliver substantial dividend payouts to shareholders in the next 12 to 18 months, as their ability to generate profits improves and regulatory requirements on capital and leverage are met.

In a recent update on the sector, Steve said: “It has been a lengthy convalescence, and while there may still be some way to go, the outlook for some of the UK banks worst hit by the financial crisis of 2007-08 now appears much brighter. This is striking at a time when several of them remain lowly valued both by historical standards and in relation to the wider market, making them, in our view, some of the strongest recovery opportunities on the UK stock market.”

Steve cited three reasons for his positive view on the sector:

UK banks are largely unloved, while profitability is improving and dividend payments are becoming more likely.

UK banks: largely unloved

“As an example, both Barclays and Royal Bank of Scotland (RBS) continue to trade below their book value. While there is no guarantee that these banks can revert to anything like the levels at which they used to trade before the financial crisis, current valuations demonstrate clearly that these banks remain largely unloved by investors. To us, this represents a good recovery opportunity.”

UK banks: profitability improves

“Yet these banks remain out of favour at a time when their ability to generate profits has improved substantially. Margins have expanded as they have benefited from rising mortgage rates while funding costs, particularly deposits, have come down. Further margin expansion may prove hard to come by but banks should see a further boost to their bottom line as UK interest rates start to rise – in our view, by early 2016 at the latest. A further by-product of the resilient UK economy is that loan demand is starting to perk up [1] and should continue to strengthen in the months ahead. The economic recovery has also sparked a dramatic fall in impairments [2] , with RBS only reporting in September last year that it would have to set aside less money to cover bad loans than it had initially forecast.

“Additionally, profitability at UK banks has been enhanced by the implementation of serious cost-cutting measures: Lloyds Bank, for instance, has had its “Simplification” programme in place since 2011, and now expects it to deliver savings of £2bn in 2014 [3]; Barclays announced last year it would cut 19,000 jobs over three years and shrink its investment banking operations [4], RBS meanwhile has been undergoing a substantial restructuring programme since the start of the financial crisis, including the disposal of non-core assets such as its US subsidiary Citizens Bank and the future sale of Coutts International and Williams & Glyn.”

UK banks: Dividend payments

“If UK banks then are becoming more profitable, the question must be asked as to whether they are now in a position to return a share of those profits to shareholders in the form of substantial dividend payments. In our view, they are. Up until now, profits generated by the banks have either gone to pay fines such as payment protection insurance (PPI) or have been retained on their balance sheets in order to satisfy regulatory requirements for higher capital ratios. Further provisions for PPI are inevitable in 2015, so this issue is certainly not fully behind us yet, although we would hope to see a further decline in the magnitude of these provisions. Some other hurdles remain to be overcome: Barclays has yet to agree to a settlement with regulators over alleged manipulation of the foreign exchange markets, while RBS remains under investigation in the US in relation to the mis-selling of mortgage-backed securities.

“Progress on capital requirements has been much more encouraging. The Bank of England’s Financial Policy Committee set leverage ratio requirements we view as sensible rather than overly draconian. In addition, all UK listed banks passed the extremely severe stress tests carried out by the Prudential Regulatory Authority at the end of last year.

“Against this backdrop, we believe UK banks should be able to make substantial dividend payments to their shareholders in the next 12 to 18 months. The first test, in our view, will come when Lloyds announces its full-year results on 27 February. If the bank is allowed to pay a token dividend for 2014, we think it would send a very strong signal to the market that UK banks have turned a corner.

“We believe Lloyds is capable of generating as much as 10 pence a share of profit, of which at least 50% could be paid out as a dividend, if not more given the bank’s moderate growth outlook. In such a scenario, it would imply an annual dividend of at least 5 pence a share, although we think it may be closer to 7-8 pence; that would support, in our view, a share price well above 100 pence compared with a current price in the region of 75 pence.

“The situation appears a little different at RBS. In our view it still has some way to go with its restructuring programme but it is not inconceivable that it could start paying a dividend in 2016. As for Barclays, the bank has continued to pay a dividend even through the lean years and should be in a position to increase payments if the new executive team, led by Chief Executive Antony Jenkins, can deliver on the targets set out in its Transform programme [5].”

However, as always with investments, there are risks to this positive scenario

Steve concluded his update with a word of caution: “While UK economic growth has held up well so far, it is not immune from the slowdown in growth we are seeing elsewhere around the world. The UK banking sector, like the rest of the UK economy, would be affected should this global slowdown gain momentum. Banks, meanwhile, still remain vulnerable to PPI payments and uncertainty over the scope of the fines that might be imposed on them amid ongoing investigations into their activities.

Finally, a UK general election is looming and Labour leader Ed Miliband has made no secret of his wish to break up the high street banks [6] – a threat, if carried out, that could have the biggest repercussions for Lloyds and RBS. However, with an official competition inquiry already in progress, the Labour leader’s hands might be somewhat tied by the findings of this inquiry were he to make it into government.”

Sources:

  1. Bank of England, Money and Credit report, November 2014 (page 8)
  2. The Telegraph, 30.09.14 “RBS’s ‘bad bank’ and impairments improve on economic upturn”
  3. Lloyds Strategic Update, 28 October 2014
  4. Reuters, 08.05.14 “Barclays axes 19,000 jobs, reins in Wall Street ambitions”
  5. Barclays Transform, 02.14
  6. BBC, 17.01.14

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Steve's views are his own and do not constitute financial advice.