Outlook positive for financials

Investor: The banks' results season is currently getting into full swing in the UK. Northern Rock and Barclays have already reported and between now and March 6th heavyweights such as Royal Bank of Scotland, HBOS and HSBC are due to report their second half and full-year 2005 results.

Prior to the emergence of the Celtic Tiger economy, developments in the British banking sector had a significant impact on Irish financial stocks. In recent years, however, the introduction of the euro and solid performance of the Irish economy means that this influence has diminished. Nevertheless, trends in British banking still have relevance for Irish stocks, and Bank of Ireland in particular which is very active in the British buy-to-let mortgage market.

During the fourth quarter the British banking sector recovered from some of its earlier underperformance. This underperformance was driven by the slowdown in the British housing market and worries about potential bad debts. However, since the beginning of the year the sector has improved as evidence mounted of a stabilisation in the housing market. House price inflation has stabilised at around 3 per cent and there are encouraging signs of a pick-up in activity levels.

A rise in personal sector savings has also boosted business for the banks. Finally, share prices received a further fillip from renewed bid speculation in relation to Lloyds TSB.

Irish financial stocks have also had a strong start to the year, with the two big banks leading the way. Bank of Ireland, with a market capitalisation of just under €15 billion, is up 11 per cent with AIB up by 8 per cent.

AIB retains the top spot in terms of size with a market capitalisation of close to €17 billion. Irish Life & Permanent is up 4 per cent while, for once, Anglo Irish has lagged with a gain of just 2 per cent. Given Anglo's phenomenal share price performance in recent years its shareholders are unlikely to be concerned by a minor pause in performance. These returns compare with a gain of just over 5 per cent in the Iseq overall index.

Of course the question at the forefront of investors' minds is whether the Irish financials can deliver further gains in 2006. While the absolute return from Irish bank stocks has been good in recent years, the return relative to a strong overall equity market has been disappointing, with the notable exception of Anglo Irish Bank.

There can be little doubt that underlying business trends affecting Irish banks look very solid over a 12-18 month view. Global macro-economic conditions look set to remain favourable, but more particularly the overseas markets that are relevant to the Irish banks are in good shape.

AIB's interests in the US and Poland are currently performing well, while the improved sentiment in the British housing market should benefit Bank of Ireland.

Ireland remains the key market for all Irish financials and domestic news continues to be good. Loan growth, which is arguably the mainstay of any bank's business, is growing at an annual rate in excess of 25 per cent. Despite worries regarding an overheated housing market, current momentum is such that it is difficult to see any significant slowdown in 2006. With such all-pervasive strength in the economy the incidence of bad debt is set to remain low.

On top of buoyant underlying economic fundamentals, the SSIA bonanza is set to generate extra activity over the next 12-18 months. The impact that the maturing SSIA money will have on the financial sector is unquantifiable. However, Investor has long held the view that it will have a significant positive impact on all Irish financials.

Furthermore, all of the good news is not yet discounted in current share prices. The historic dividend yield for each of Bank of Ireland, AIB and Irish Life & Permanent hovers around 3.4 per cent and, with dividend growth running at 10 per cent, the prospective yields for 2006 are close to 3.7 per cent. These are attractive yields compared with short-term interest rates and inflation.

The Irish banks also look attractive on a price/earnings (p/e) ratio basis. Bank of Ireland's prospective p/e ratio is 10.5, AIB's is 11.8 and Anglo's is 13.1. With earnings growing in the 10-15 per cent range, these are not demanding ratings.

They also compare favourably with the valuations of UK banks where, for example, Barclays is trading on a p/e ratio of just over 11.

The only obvious negative factor affecting Irish banks is the continued margin erosion due to the intensification of competitive pressures. This will l not negate the other positives though.