Stock market

Should I buy cheap bank shares like Lloyds and Natwest?

Image source: NatWest Group plc

The past few years have not been good for British banking shares. For example in the last five years Lloyd’s (LSE: LLOY) and Nat West (LSE: NWG ) have fallen 22% and 2% respectively. Both now trade at a price-to-earnings ratio of less than seven, making these shares look cheap.

A common way to value bank shares, though, is not to use earnings but book value instead. However, even on this basis, shares in Lloyds and Natwest look cheap.

Both are trading at a substantial discount to book value. In each case, buying a share now would give me a (theoretical) piece of the bank’s asset book for at least a quarter of its value. I say theoretical because buying a share in a bank does not by itself entitle me to a part of its assets. But the point is clear: these shares in leading British banks look cheap.

Persistent concerns about the banking sector

But wait – other investors have access to the same information as I do. However, both the shares have declined in value over the past few years.

If these are really cheap shares – with a dividend yield FTSE 100 average (5.5% for Lloyds and 6.2% for Natwest) — why aren’t investors snapping up share prices in droves?

One explanation is that investors have been burned before.

Bank stocks underperformed during and after the 2008 financial crisis. Both Lloyds and Natwest shares are a fraction of what they were before.

It is no coincidence that for many years the government has been NatWest’s largest shareholder. He stepped in to bail out the bank when it was in dire straits.

Another concern investors like me have is that it’s not clear whether banking stocks are as cheap as they look.

Take the price of a book as an example.

It largely depends on what the prices are considered to be. But in the property market, for example, a house worth £250,000 today does not mean it will actually be worth it a year from now.

The fear holding back many investors is that a weak economy could raise default rates on loans. This could hurt the profitability of banks such as NatWest and Lloyds, the country’s biggest mortgage lenders.

Potential value at current prices

For now, though, signs of that happening are limited.

Last year, Lloyds saw a 41% rise in after-tax profits to £5.5bn. Growth at NatWest was a smaller but still impressive 23%, to £4.7bn.

If anything, banking earnings look strong and may have room for growth in the future.

After all, both banks enjoy widespread name recognition, have large customer bases and operate in an industry known for its ability to generate substantial profits. They proved it last year.

If that happens, both look like cheap stocks to me now.

But I think the global economy remains fragile, which poses continued threats to banking profitability. I’m coming back to this sector as an investor — but not ready to buy just yet.

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