Time to stop banking on the financial sector's rise

The Investment Column

The strong run in banking shares this year has helped the FTSE 100 index scale new heights, but analysts are divided about the sector's prospects, particularly in the wake of the debacle at NatWest. According to the bulls, the outlook remains good, supported by a benign economic environment of low inflation and low interest rates, which reduces bad debt provisions and improves earnings quality.

That has been one of the driving forces of the sector's dramatic outperformance of the rest of the market in recent years, because investors have been prepared to accept a lower risk premium for holding the shares. There has also been a cyclical rise in profits and the perception that the management of banks has improved.

The industry's fundamentals are sound. While consumer borrowing growth is running at an annualised rate of 12 per cent, overall bank lending is expanding at around half that, equivalent to the increase in nominal gross domestic product. That has allowed banks to keep margins up.

The problems at NatWest and doubts about Barclays' strategy with Barclays de Zoete Wedd are likely to be confined to those two banks, on this optimistic view. The poor quality of securities trading and corporate finance profits will not be the same worry for the likes of HSBC, which is pursuing a more focused attack on investment banking, or Lloyds TSB, widely viewed as the sector's benchmark.

Meanwhile, there are plenty more efficiency gains to come as more labour is shed. Assuming the traditional banks can keep up with the shift towards electronic and telephone-based distribution, they should benefit from the lower cost bases enjoyed by the direct suppliers.

The counter-argument to this rosy view is based on past banking cycles and the distortions to bank ratings caused by this year's building society conversions. There is no question that bank shares have been pushed up ahead of the arrival of Halifax on to the market as index tracking and other institutions have scrambled over themselves to build up their weightings.

The normal institutional holding in a Footsie company is close to 80 per cent, yet all the Halifax shares were initially dished out to its savers and borrowers. It will take several years for the big hitters to build a full weighting, which should underpin the shares.

But despite weakness in the past few days, banking share prices look worryingly vulnerable to signs that they are not able to sustain their impressive return on equity. Banks are facing criticism for their high margins and there are signs of pressure on returns. Meanwhile, bad debts are starting to creep up. All this is anecdotal as yet but, if past history is any judge, it is during good times such as these that banks sow the seeds of their own nemesis.

Sutcliffe finds the right chemistry

Sutcliffe Speakman's marriage to solvents distributor Samuel Banner at the end of 1995 did nothing for earnings last year, but still looks a wise move. Results for the year to March showed a fall in the combined group's headline earnings from 2.58p to 2.44p, largely due to a dramatic drop in chemicals prices which cost Sutcliffe around pounds 400,000. Prices of certain esters and glycols plunged by around 50 per cent. With Banner on board, chemicals now represent over two fifths of total sales.

Including Banner for a full year, as against three months for 1996, flattered profits and turnover comparisons. Excluding a pounds 650,00 restructuring charge and discontinued businesses, operating profits were 89 per cent up at pounds 5.8m on turnover 90 per cent ahead at pounds 71m.

Banner may have been a drag but, longer term, there is plenty of logic in the merger. Sutcliffe, whose shares hit an all-time low of 15p in February 1995 following a profits warning and a walk-out by senior management, has been struggling to sell its hi-tech, high margin carbon products which absorb poisonous vapours from chemical processing. Buying Banner, which distributes chemicals to blue chips like BASF and Du Pont, gives Sutcliffe a distribution network and turns the combined group into a one-stop source of solvents and solvent disposal packages. One potentially exciting machine is Sutcliffe's Bioreactor which uses bacteria to "eat" toxins. That is being marketed to chemicals customers, but pharmaceutical and printing industries are obvious customers.

Worries over power tussles between Sutcliffe and Banner directors were also allayed. Banner's Stuart Lloyd is running the show as chief executive and the last of the old guard went yesterday with the resignations of both David Martin, who was appointed Sutcliffe's chief executive just before the merger, and Adrian Fontes, Banner's old finance director.

House broker Charterhouse is forecasting pounds 6m profits for the current year. Mr Lloyd says chemicals prices are more stable, which helped push the shares up 1p to 24p yesterday, and with European legislation driving the market for chemical clean-up equipment, a forward p/e ratio of 8 makes the shares look cheap.

Internet provider has huge potential

Internet Technology, chaired by Jan Murray, founder of the computer superstore group PC World, is one of a growing band of companies which provide access to the Internet. This rapidly expanding global computer network has captured the public imagination and it seems that any company associated with it attracts a high rating. But its development in the UK is still in its infancy. None of the Internet-related groups are making any money as yet and some, like Demon, have run into financial difficulties. That said, Internet Technology, which floated on AIM last year after the reverse takeover of a property shell company, looks more financially robust than most.

It is still making a loss, pounds 1.2m in the last six months, but its expansion is gathering pace and it is now the third largest access provider in the UK. By selling the property portfolio, it has been able to fund a successful marketing campaign and keep its cash flow ticking over nicely. Subscriber numbers have risen from 11,000 to 26,000 in the last year and it is now adding customers at a rate of 700 a week. The recent acquisition of a smaller rival, Xara Networks, will also help it get a foothold in the lucrative market for corporate customers.

Of course there are risks. British Telecom has set up its own Internet access service which could squeeze smaller players and the Internet may not take off as most computer enthusiasts expect. But Internet Technology is well positioned to continue to grow rapidly. It should also make a tidy profit from its stakes in two unquoted hi-tech stocks, Xarr and Redstone Network, which are due to float shortly.

SGST, the broker, forecasts Internet Technology should make a loss of pounds 860,000 this year. Then it should break into the black next year with profits of pounds 1.5m, putting the shares - up 1p at 90p - on a prospective p/e ratio of 23. The shares, which have doubled in the last few months, are not cheap but Internet Technology's huge potential justifies its rating. Hold.

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