UK bank s may look cheap, but this is as good as it gets

Serious Money: Financial companies of one sort or another, but usually some kind of bank, have grown to the point where they now dominate economies and markets.

In terms of profits, for example, US bank earnings now comprise a bigger share of GDP than at any time in history. And no other sector of the stock market comes close to that level of profits.

One or two individual firms may be more profitable than banks but there is no group of companies that is as dominant as the financials. In many ways, it is hard to be bullish about the equity markets without being bullish on the banks, and vice versa. Valuation, rarely a straightforward topic, is particularly tricky when it comes to banks.

The modern drift away from earnings-based valuation measures, to ones that focus on free cash flow, rather comes unstuck with banks, as some of the relevant concepts tend to become blurred.

In particular, once we start to think about it, the whole concept of "capital" is rather hard to pin down when it comes to banking. Measures of profitability, based on return on capital, have to be carefully handled for banks. Given the difficulties inherent in valuing a bank, many analysts fall back on our old favourite, the price/earnings (PE) ratio. Imperfect it may be, but lots of people still prefer it when it comes to financial stocks.

When we look at European bank PE ratios, it is hard not to conclude that bank stocks are cheap. In the case of UK-based banks, very cheap.

Why would the market put such a low valuation on UK banks? Many of them stand on a PE multiple of just under 10 times next year's earnings: a substantial discount to the rest of the market.

We have just been treated to a series of media headlines about the "obscene" profits made by high-street banks: profitability is at record levels and all of the various management teams are expressing confidence in the future. Such are the levels of cash being generated by the banks that we see some commentators calling for windfall taxes.

Returns-based measures confirm the impression of a fabulously profitable sector. Returns on equity (the most appropriate measure for a bank) are often well over 20 per cent.

An economist would be tempted to conclude that the banks that protest that they are involved in a competitive environment are merely attempting to pull a lot of wool over the regulator's eyes.

Indeed, an ex-regulator has complained that his recommendations, made several years ago to open up competition, have been studiously ignored by the government.

The argument here is a bit esoteric but relates to access and control over the payments mechanism: the suggestion is that the banks have got this key part of the market cornered. This means there is an effective barrier to entry.

Without barriers to entry, any Tom, Dick or Harry could set up as a bank and immediately earn 20 per cent plus on his investment. Despite the noble efforts of one or two internet-based banks, no new major force in UK retail financial services has emerged in decades, consistent with the idea that high levels of competition are merely a figment of bank imagination.

An effective oligopoly that will maintain high earnings forever: the stock market cries out for such opportunities. What is it about banks? Why are investors so sceptical? Are banks a screaming buy?

The market could be betting that the regulator will eventually grow a backbone and inject some proper competition. This looks unlikely to me. The orthodox view within the UK is that the authorities should err on the side of a strong banking system. Too much competition could threaten the existence of one or two banks which would be bad for the economy and, say the cynics, shut down a jobs-for-the-boys conveyor belt that sees ageing government officials end up on the boards of UK banks.

Inevitably, the answer to this conundrum is quite complex. There are four or five main drivers of bank profits: loans, non-interest income, net-interest margins, costs and bad debts. For a decade or more, four of these five drivers have been working in the banks' favour.

Loan growth has been astronomical (the housing market), costs have been falling (outsourcing to India and mergers), bad debts have collapsed to virtually nil and non-interest income has generally been growing strongly. Only net-interest margins have been working against profits - which is, incidentally, how the banks can point to some evidence of competitive pressures.

All of these favourable movements in drivers of profitability are about to reverse and margins are likely to keep falling. The stalled housing market is already putting pressure on loan growth and bad debts cannot fall any further.

Falling service standards are meeting customer resistance so costs may not be able to be cut much further.

The reason why banks look cheap is that the market knows that this is as good as it gets for UK banks. While the environment may not deteriorate rapidly, it can't get any better. And, as it turns out, another key variable is about to enter the valuation equation, one that relates to our earlier discussion of bank capital. Whatever that capital is, the banks are about to start generating mountains of it, far more than they will ever need.

The business may be about to decline, but cash generation from those 20 per cent plus returns is prodigious and will remain that way for some time.

What the banks do with their surplus capital will be a critical driver of share prices: if the money is invested wisely (profitable organic growth, value-enhancing mergers or simply returned to shareholders) then we will probably look back on today's share prices as a bargain. But it is a big bet to argue that bank management teams will always and everywhere make the right decisions.

So, the fundamental operating environment for UK banks is about to decline. Fast or slow - we don't need to have a view, the peak has been seen.

Management have to deal with this and cope with abundant cash. Limited (profitable) growth opportunities and management teams with cash burning holes in their pockets: who would want to bet that this is a recipe for further shareholder value creation? Not me, certainly.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.