Is the banking sector overvalued? A number of observers believe it now is. Some see the sector as being cyclical, and believe that a downwards spell is inevitable before too long. They see the increasing amount of consolidation in the banking industry as evidence of a forthcoming end to the recent banking mini-boom.
The latest planned takeover in the sector, announced a week ago, took many by surprise. Of the big banks, Lloyds TSB has the reputation of being rather acquisitive, and people pretty much expect to see takeovers by the company on a fairly regular basis. It last did this in June, with the buy-out of Scottish Widows, and it looked like it might be about to do it again after rumours circulated about Legal & General. This rumour, which we will come back to later, turned out to be wrong, but it did force the genuine predator, in the shape of NatWest, to show its hand. The confirmation of that proposed deal brought a lot of "me too" investors out of the woodwork, and shares in other, smaller banks and insurance companies rose sharply immediately afterwards, in the hope that they too might become takeover targets.
What has fuelled the takeover and merger fever in the otherwise sedate world of banking and finance? For one thing, with a growing number of new Foolish investors shaping their retirement plans around stock market investments, there are more and more people looking for growth in the businesses that they buy bits of. The days of shareholders sitting back, happily accepting their dividends every year, and putting no pressure on the management of their companies are pretty much behind us. Freer competition in the sector, the growth of telephone and internet banking facilities, and the emergence of a number of new upstarts has also shaken the old world a lot, and they have to become lean and mean to stay ahead.
But when it comes to growth, it is hard for banks to achieve it organically for any great length of time. Organic growth is simply growth in the existing business, and it is achieved through the increasing turnover that comes from selling more products to more customers, and through raising profitability via cost savings and increased efficiency. Growth these days, at least for the big banks, means acquisition, and a subsequent expansion into other areas of the financial services industry. With the demutualisation of so many building societies and insurers over the past few years, there is no shortage of targets for takeovers.
However, the prices paid for takeovers seems to be rising, and the value NatWest is placing on Legal & General - on the face of it - doesn't make it look like much of a bargain.
The part paper bid (which just means that it'll be paid for partly in NatWest shares) initially valued L&G at around pounds 10.7bn - probably more than twice its worth - based on the net value of its business.
NatWest is clearly expecting healthy future profits to arise from using common sales channels for products and from efficiency savings via synergies. Even so, the deal is only likely to produce a return on investment of around 5 per cent, and you could get that with much lower risk by putting your money in a savings account.
So is the banking sector overvalued? Well, there is certainly evidence that valuations are high by historic standards. Valuations mooted for takeover deals are increasing, and that might not be stomached by the predators' shareholders for much longer.
NatWest's share price, for example, has fallen since the bid was announced, thus devaluing the takeover offer.
On the other hand, banking technology is improving rapidly and competition for our savings and for our insurance premiums is hotting up. Investors and savers are also becoming less tolerant of the huge commissions charged on many financial products, and a move towards more direct, and lower cost, selling is inevitable.
There will be some long-term winners in the banking and finance sector for those who are patient, but Foolish investors need to weigh the balance. We should always be wary of paying too much for an investment, if we cannot see where the future profits are going to come from to justify the price.
And that rumour we mentioned earlier, that an offer for L&G was in the pipeline? That was triggered when L&G's share price rose 10 per cent on the day before the bid was announced. An investigation into possible insider dealing is likely to be instigated. Insider dealing, being tantamount to theft, is illegal - and is to be despised by all honest investors.
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ASK THE FOOL
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Over the long term the small fluctuations we see become meaningless anyway.
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MY DUMBEST INVESTMENT
I bought some Pizza Express shares at just under pounds 8 in July. I was then disappointed to see them fall sharply last month and sold out at 715p to cut my losses. After that they fell a bit further, but the price has now come back up to almost what I paid for them. Selling when I did was dumb, but how could I have known?
The Fool responds: Making your buying and selling decisions based on short-term price changes is definitely not Foolish. Foolish investors base their decisions on the long-term prospects of their companies and ignore the short-term "noise" created by day-to-day price movements.
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