Takeover-spotting keeps bank sector on the boil

Tom Stevenson believes there are good reasons for the re-rating - in spite of competition worries
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The stock market's love affair with the banking sector showed no sign of abating this week. With the notable exception of NatWest, all the banks to have reported their results in the past two weeks have received welcomes ranging from the warm to the frankly ecstatic. Barclays brought proceedings to a dramatic end on Thursday, with the promise of a bigger share buyback than expected sending its shares into the stratosphere.

Being fully invested in the banks over the past year or so has been the only sure way of participating in the soaraway stock market. With more than a quarter of the value of the FTSE 100 accounted for by the financial sector, the banks have arguably been the market in recent months. A year ago Lloyds TSB's shares were trading at 346p, now they are worth 742p. Standard Chartered has all but doubled over the same period.

There are good reasons for that dramatic rerating of banking shares. In an environment of low inflation coupled with sustainable growth, the earnings quality of financial institutions improves as fewer companies go bust. Banks have also become much better at managing their costs and weeding out underperforming businesses.

Importantly, capital is being managed as a scarce resource rather than as the "free" source of funds it has been viewed as in the past.

But what has surprised some analysts in the past two weeks is the extent to which share prices, which should already have factored in much of that good news, have continued to rise despite a set of results that have been good but not stunningly so. Barclays, for example, reported a modest 8 per cent rise in underlying profits but saw its shares add the best part of 10 per cent on the day of its results.

What appears to have happened is a shift in focus from the fundamental attractions of the sector - where there are quite serious worries about the incursion of the former building societies and a persistent squeeze on margins - to its potential for consolidation.

Investors are increasingly looking for the next takeover candidate, regardless of its underlying prospects.

That consolidation needs to take place has been clear for a number of years, but it has taken the movement of the former building societies into product lines traditionally seen as the preserve of the clearing banks to concentrate minds on the over-supply of banks on British high streets.

Another interesting feature of the reporting season has been the extent to which generalities about the banks have become invalid.

The seven banks in the table below are producing very different returns on their capital because they have become very different sorts of companies. The forces driving a global player such as HSBC are plainly very different from those driving LLoyds TSB, which has made a conscious and successful decision to focus on the retail side of the domestic market.

The star of the season was undoubtedly Lloyds TSB, where the potential for further cost-cutting from the merger of its constituent parts in 1995 continues to boost expectations.

It has avoided the temptation of battling it out in the competitive investment banking world and seen its return on capital soar to a massive 40 per cent as a result.

At Barclays, the battle to turn BZW around appears to have been won and the return on equity at the investment bank of 12 per cent, while hardly better than its cost of capital, is at least moving in the right direction. Barclays is handing bucketloads of cash back to shareholders, arguably not what its management is paid to do but better than squandering it as in the past.

HSBC and Standard Chartered march to a different tune and both, in different ways are making a success of their overseas franchises. Standard cashed in on the currency turbulence in South-east Asia. HSBC continues to benefit from the booming economies of Asia and is building up a meaningful franchise in Latin America.

The black sheep of the sector continues to be NatWest, although its plight appears to have been exaggerated by a press that has scented blood. Certainly its investment banking arm is still in trouble, returning just 2.4 per cent on its capital, but what NatWest appears to have got most wrong is to allow the perception of the bank as a loser to get such a firm grip. Its biggest error has been to allow itself to look weak when, all around, its rivals were looking stronger than perhaps they really are.