Unloved, but are bank shares also underpriced?

After their public battering in recent times, banks have been among the best stock-market performers, but don't expect a smooth ride from now on

It's been an eventful year for banks, to say the least. From Standard Chartered's fine for allegedly hiding transactions with Iran, to Bob Diamond's resignation from Barclays over Libor rate manipulation – you wouldn't think bank shares were the place to be this year.

And it seems there are more storms gathering on the horizon, with the Serious Fraud Office expected to file charges imminently against former traders over the Libor scandal.

But despite the torrid times banks have gone through recently, financials have been the best performing sector over the past few months, even though they have remained widely unpopular. If banks are so unloved by the masses, to the point where they are really cheap, the question is: is it time for you to be investing in them?

"If you ask a group of investors what's happened to banks this year, they'd all say they've gone down – they have a negative perception," says Mark Dampier, the head of research at Hargreaves Lansdown. "Sentiment is so poor against them – if more people say 'don't go there', you might be able to make an investment case for them."

Even though bank shares have done particularly well over the past few months, they have come from a pretty low level, having been severely beaten up, and some fund managers believe there's still a lot more room for share prices to go up.

"Banks are one of the cheapest and most unloved areas of the market. They have been unloved for a long period of time – a proper reason to have a look at them," says Guy de Blonay, the manager of the Jupiter Financial Opportunities fund. "You should probably look at UK banks again, because you want to look at a sector ahead of their return to the dividend register."

He adds: "These companies are on the mend, trading at very attractive valuations, and over the next three years will be able to come back and pay a dividend."

Giving credence to this view, Royal Bank of Scotland's chief executive, Stephen Hester, recently said the bank might be able to resume dividend payments to shareholders after 2013, which Mr de Blonay says bodes well for the sector as a whole.

Many of the risks facing banks are also ones that could soon blow over, rather than dog these institutions for years to come. Mr de Blonay says: "There are all sorts of 'one-off' risks that are lingering – but these are not long-term risks, and the stock price is already telling you this. So buying shares in RBS, for example, is already discounting such one-off events."

Shunning the sector might also mean missing out on some fleeting buying opportunities. "It is rare to get the chance to buy a franchise-leader like Lloyds – one that has a 30 per cent share of the domestic and small corporate banking market – at this level of valuation," says Sanjeev Shah, manager of the Fidelity Special Situations fund.

"Banks continue to be unloved by most investors, and despite strong performance of late, the sector continues to trade at depressed valuation levels," Mr Shah says. "In the short term, the economic environment is obviously tough, but on a longer-term view the recovery prospects remain strong."

However, there are other risks that could mean banks are not worth investing in. "My problem is that they're not transparent – no one could understand them," says Mr Dampier.

"The bank culture has been like this since I started – we've seen the payment protection insurance mis-selling, now there's the manipulation of Libor – what else is there to come out? You could say it's in the share price – maybe it is, maybe it isn't – but do you really have to be in banks? They are not paying dividends, either."

Mr Dampier says Neil Woodford at Invesco Perpetual, one of his top fund manager picks, has stayed away from banks for a while and has not shown signs of wanting to buy back in. Mr Woodford has owned bank shares in the past, and in the 1990s had about 30 per cent of the Invesco Perpetual Income fund invested in the sector, with Lloyds as a large holding.

The unstable situation in major economies is another reason to be wary of plunging into bank shares. Philippa Gee, at Philippa Gee Wealth Management, says: "I would be highly sceptical about investing in banks as a short-term money-making market opportunity. I personally doubt that we have completely finished the bad news about banks and with a possible further correction in markets, you could see bank stocks fall back."

Indeed, knowing when to buy and sell shares is tough, even for seasoned day traders, so opting for a collective investment fund could be a wise move. Ms Gee tips the JPM Global Financials fund, where its largest regional holding is the US, at just under 40 per cent.

"I would suggest investors also look at more diversified funds, such as Artemis Global Growth, which currently has approximately 16 per cent invested in banking stocks, or Liontrust Income – a UK rather than global fund – which currently has about 19 per cent in financial stocks," she adds. "Be very wary of being too specific in your investment approach – it can work well but it could also expose you to unacceptable levels of risk to your capital."

Although funds investing solely in financials are likely to undergo a choppy ride in the short-term, returns could be highly attractive over a longer time-scale. Ben Seager-Scott at Bestinvest says: "For investors with a long-term view, I would suggest Jupiter Financial Opportunities. While the fund has not participated in some of the rallies of recent years, it demonstrated the strength of this approach by avoiding the ugly falls following the collapse of Bear Stearns in 2008."

Caution is the watchword, then, when looking to invest in banks, and one option is to go with a diversified fund run by an experienced manager to gain this exposure as shares languish at cheap prices. Even then, remember that this sector has its own peculiar problems which could be exacerbated if the global economy takes a turn for the worse.

Emma Dunkley is a reporter for Citywire.co.uk