David Kuo: If you're attracted to banks, choose the good, not the bad or the ugly

Investment Insider

The question that I am asked most often about investing at the moment is whether banks are a good investment. It isn't hard to understand why many private investors have been drawn to banks. Anyone who picked up shares in Barclays when they fell to a low of 51p in 2009 will be laughing all the way to the... bank.

The shares have gained 382 per cent. In other words, a £10,000 investment would have turned into £48,200. These are the kind of explosive returns you would expect from speculative oil explorers, dicey miners and chancey prospectors, not from banks.

So, it is understandable why many private investors are wondering if Royal Bank of Scotland and Lloyds Banking Group could repeat Barclays' trick and stage dramatic recoveries. They might.

However, before we take a punt on banks, it is advisable to get to grips with their complex accounting systems. Unfortunately, even at the best of times, banks behave like sausage machines. Money goes in one end and, mysteriously, money emerges from the other end in the form of bonuses for executives and dividends for shareholders, if we are lucky.

Most people will agree that the financial accounts of banks are at best messy and at worst totally unfathomable even for people who are supposed to be experts. If the experts were half as good as they think then we would not be in the financial mess we are in now.

You only have to look at the profit forecasts for Lloyds Banking Group to see how confusing it can be. For instance, City analysts had reckoned the bank could either report a profit of £3bn or a loss of £890m this year. On Friday, we learnt that the part-nationalised bank had lost £3.2bn, largely due to claims relating to PPI mis-selling. How on earth can anyone make a sensible investment decision when the forecasts range from a healthy profit to an unhealthy loss?

There is another issue and it concerns the long-term total return from bank shares. The total return comprises capital appreciation, which is when shares rise over time, and reinvested dividends. Unfortunately for banks, the total returns show a divide between banks that have amply rewarded shareholders and those that have comprehensively destroyed value.

Standard Chartered has been a stand-out performer over the past 11 years. It has delivered a return of 174 per cent, which equates to an annual return of 9 per cent. Put another way, a £10,000 investment in Standard Chartered in 2000 would be worth around £27,400 today with dividends reinvested.

HSBC's return has been less impressive but nonetheless positive. A £10,000 investment in HSBC would be worth £11,900 or 1.4 per cent a year. Lloyds has destroyed 85 per cent of shareholder value and RBS investors have seen their investments collapse by 90 per cent.

The total returns speak volumes but there is something less tangible that investors should consider. This is stewardship, or how bosses treat their shareholders. The should be transparent, communicate with shareholders openly and aim to keep salaries and bonuses at reasonable levels. One measure of reasonableness is to only consider bonuses if shareholders have been rewarded with acceptable long-term total returns. In other words, bosses' rewards should be in line with shareholder rewards.

In difficult times companies with good stewardship can distinguish themselves with exemplary behaviour. Over the next few weeks look at the way banks reward their bosses. Are they eating from the top table while shareholders are made to beg for scraps?

Then ask yourself if you would entrust these people with your money because as a shareholder you are a part-owner of the business. That should provide a useful clue as to whether a bank is worth investing in.

David Kuo is the director of the financial advice site fool.co.uk

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