Many commentators have recently opined that banks are now trading at levels which makes them cheap as a ‘long term‘ purchase but that volatility is too high to make that an easy decision for professional investors, virtually all of whom are measured over the short-term. This view is apparently formed from the low p/e, high dividend yield and close proximity to asset value at which most UK listed banks currently trade. We however have our doubts that even long term value is obvious.

The last decade or more has provided a benign background for banks to grow their earnings through significant increases in their balance sheets. In the good times, the high level of profits relative to equity was lauded despite these high returns being such because of the low level of equity. However, as we drift into the not so good times, the low level of equity is clearly in focus but is now a clear negative particularly when compared to the high level of assets on the banks’ balance sheets. And with the quality of those assets being increasingly questioned, the small amount of equity which is supporting them becomes ever more vulnerable.

Perhaps a short sharp economic downturn will occur in which case the banks’ balance sheets may be strong enough to withstand further bad news. However, a more drawn out downturn, especially a severe one could increase bad debts beyond even the most bearish expectations, thus necessitating more rights issues from the banks. (It is interesting to note that economic growth is still reasonably robust in the UK but we have already seen rights issues from Royal Bank of Scotland, Bradford and Bingley and Barclays). That is not the only driver for equity issuance. The regulatory authorities (The FSA? The Bank of England? The Government?) may feel that we have been lucky to escape with only the Northern Rock actually being nationalized and force the remaining banks to strengthen their balance sheets.

There is no doubt that strong bank balance sheets are good but they do reduce the likely returns on equity a bank will generate and this feeds through into a lower premium to book value at which the banks should trade.

One should not be too negative though. We believe there are some fantastic franchises in UK banking which are capably of generating very high returns for their shareholders. Lloyds TSB and HBOS valuations are low enough for us to have established small holdings and unless newsflow deteriorates very substantially from here we would expect to increase our holdings if these shares move lower.

This article is not investment advice or a recommendation to buy any share or fund mentioned directly or indirectly, and should not be relied on in making any investment decision.

Please note that the opinions expressed in the above article are the opinions of the author alone, and do not necessarily represent the views of Investec Asset Management or its associated companies.

Investec Asset Management, or any of its associated companies or employees (including the author), may hold positions in any of the securities mentioned in the above article or in related securities including Temple Bar.

For more information on Temple Bar visit www.templebarinvestments.com