Consider going small when purchasing bank stocks to get the best deal

Terry Tanaka claims that although bankers enjoy creating bloated, international empires, their investors seldom profit from this

Over the past 18 months, UK banks have done well after a few decades in the doldrums. Since 2024 began, the FTSE 350 Banks index has increased by 70%, outpacing the US SandP Regional Banks index (up 12%), as well as the Nasdaq (up 35%).

Commonsense "buy and hold" investing rarely works when it comes to banks: HSBC and Standard Chartered, the top performers over the last 20 years, have seen their share prices fall behind inflation while diluting shareholders through capital raisings over time. A counterintuitive strategy has yielded better outcomes: purchase the lowest-quality banks after the sector's fortunes have completely turned around. This time, the results are the same: the top performers have been Metro Bank (up 196%), followed by NatWest (up 147%).

Two challenges faced by UK banks since the crisis have now been overcome: interest rates have increased significantly above their pre-crisis lows, and loss-absorbing equity funding has been reinstated. While low interest rates are typically viewed as advantageous for banks, they lose any relative advantage over funding in wholesale debt markets when the cost of money drops too low. Current account deposits are a dependable and inexpensive source of funding.

Naturally, the UK banks would not have had to deal with the issues brought on by low interest rates for the past ten and a half years if they had not initially made so many loans that interest rates had to be lowered below one percent. However, banks have re-rated from trading at 2550% discounts to tangible book value (TBV) to about 11 times TBV now that the interest-rate cycle has returned to more normal levels and equity cushions have been restored.

The banking climate is so benign that Shawbrook, a small business lender owned by private equity firms BC Partners and Pollen Street Capital, might even make an IPO. Shawbrook is aiming for a £2 billion valuation and might go public later this year. However, considering the performance of previous IPOs, including Metro Bank, Funding Circle, and CAB Payments, which all saw declines of more than 80%, that valuation appears ambitious. Early investors who bought before they listed benefited greatly from these investments, which gave them a windfall gain at the expense of public-market investors. Buyers of the Shawbrook IPO would have to ensure that sellers aren't timing their sales to sell right before issues arise.

Stock of UK banks.

Even with the improved environment, there are still concerns regarding the UK banks' long-term growth prospects. At around 80% of GDP, household debt, primarily mortgages, is higher in the UK than in the USA and the EU (though there is significant variation in the latter, with some nations like the Netherlands and Denmark getting close to 100% of GDP). The banking system's capacity to support household and government debt is almost at its limit, which restricts prospects for domestic growth.

Despite doubling its revenue to 18 billion between 2004 and 2024, Lloyds' book value per share decreased by half to 75p. This is primarily due to the poorly thought out 2008 "rescue" merger with HBOS, which at the time had a balance sheet twice as large as Lloyds'. Barclays' book value per share doubled to 5 as of December 2024, and its revenue increased by 40% to 21 billion during the same time period. Earnings per share, or EPS, are still down a third to 35p, though. During that period, HSBC was the only clearing bank in the UK to increase revenue, book value, and EPS. However, if revenue increases by 21% and NAV per share increases by less than 80%, this translates to compound annual growth rates of less than 1% for revenue and less than 3% for NAV.

Bank stocks in small areas.

International expansion may be a source of growth for UK banks, although the results are not entirely consistent. The most lucrative areas for investors have been small, rapidly expanding regions with robust institutions, like Hong Kong and Singapore. Bankers, being uninspired and uninteresting individuals, prefer to increase their presence in countries with large populations.

Both Singapore's DBS (market capitalization of 83 billion) and HSBC (formerly the Hong Kong and Shanghai Banking Corporation), with a market capitalization of 170 billion, have long since outgrown their city-state origins. The majority of UK investors are less familiar with DBS, but their track record is superior to that of HSBC. It is three times bigger than Indonesia's biggest bank, Bank Rakyat (market capitalization of 27 billion), which has nearly 50 times Singapore's population. Additionally, it is about four times larger than Maybank, which has a market capitalization of £20 billion and is located in Malaysia, a country with six times the population.

Singapore's first prime minister, Lee Kuan Yew, is largely responsible for the much greater success of DBS and its peers OCBC and UOB in comparison to their regional neighbors. With the aid of British institutions and air conditioning, Yew turned the swamp into a first-world economy. The important lesson is that, even though banks are inextricably linked to their home economies, an appealing investment case is made up of strong institutions rather than a sizable population.

One bank that learned, and another that didn't.

Even management realized that HSBC, a bloated company with 243,000 employees and 9,800 offices across 77 countries, was experiencing diseconomies of scale, so the company has been reducing its global network in recent years. According to the most recent annual report, it has reduced that figure to 211,000 employees across 58 countries. It is far more difficult to shrink a global company than to expand it. Canada, Brazil, Argentina, and France are among the nations where HSBC has left, frequently with shame.

According to former hedge fund manager and now financial blogger Marc Rubinstein, HSBC's initial entry into the French market was straightforward: the bank merely offered to pay more than competitors to acquire Crdit Commercial de France (CCF) in 2000. After twenty years, HSBC had a hard time finding someone to take CCF away from them. Cerberus, a private equity firm, paid HSBC one euro in exchange for £2 billion in tangible book capital, 244 branches, and almost 4,000 employees. HSBC recorded a pre-tax loss of £2.03 billion in addition to a goodwill impairment charge of £700 million. A new danger has now surfaced. Compared to HSBC, which has 41 million customers, Revolut, an app-based banking and payments company, currently has 52.05 million, of whom 14.5 million joined in the last year. As it strives to reach its goal of 100 million customers across 100 countries, it has licenses in 30 countries, including Brazil and Mexico, and submitted 10 new licenses to banking regulators in 2024. Conventional branch-based banks are also under threat from competitors based in the UK, including Monzo, Starling, and Atom Bank, as well as others like N26 (Germany) and Nubank (Brazil).

Despite having more clients, Revolut employs just over 10,000 people, or 5% of HSBC's total workforce. These neobanks have structurally lower costs. Monzo saw deposits increase by 48% to 160.6 billion, while Revolut saw a 66% increase in customer balances to 30 billion. Although HSBC's customer deposits total £1.65 trillion, they have decreased from their 2021 level. The way we consider the investment case in banks is currently being drastically altered by these new competitors. DBS, however, might serve as an example of how established firms can adapt to change.

The Banker named DBS the "Global Bank of the Year," and Global Finance and Euromoney named it the "World's Best Bank." More specifically, it has significantly outperformed HSBC in terms of revenue growth, having increased fivefold over the last 20 years in US dollars. Additionally, the TBV per share has increased fivefold in US dollars, and the shares are currently trading at a nearly two-to-one multiple.

Before retiring this year, Piyush Gupta, the former CEO who led DBS for 16 years, is largely responsible for this success. DBS started its digitalization strategy in 2014 following a meeting with Alibaba's founder, Jack Ma. Employees were encouraged to study tech companies by asking "what would Jeff Bezos do" rather than "what would Jamie Dimon do". Through strategic acquisitions in Asia, including the purchase of Citigroup's Taiwan consumer unit and the acquisition of Lakshmi Vilas Bank after the latter failed in 2020, the bank has grown its modest business in India.

Ten years ago, DBS had 4.9 million customers; today, it has 18.4 million. Considering that the market capitalization is 83 billion, each customer is now worth slightly less than 4,700, while Lloyds Bank's value is only 1,800. It appears fully valued now. However, the lesson of seeking out well-managed banks in small markets that can grow strategically could be applied by investors seeking banks with promising growth prospects.

Georgian bank stocks.

Consider Lion Finance (LSE: BGEO), a London-listed company based in Tbilisi that was formerly known as Bank of Georgia and is included in the FTSE 350 banks index. Over the previous 20 years, its revenue has increased by 58 times to £1.33 billion in US dollars. Share book value has increased by eighteen times. In April 2022, when the share price was 12, I wrote my last article about Lion Finance. It's 80 today.

For £300 million, the group purchased an Armenian bank at the beginning of 2024. That amount only amounts to 0.6 times 2023 earnings or 0.6 times the historical book value. When asked about this alluring price, management responded that not many buyers could afford to pay £300 million to acquire an Armenian bank. Lion Finance confirmed to the media at the end of July that it is in negotiations to purchase a 70% share in HSBC's operations in Malta. The deal is also being pursued by Ardshinbank, an Armenian bank owned by billionaire Karen Safaryan, who made his fortune in Russia in the 1990s.

Given that its GDP per capita is nominally around £90,000, Singapore is undoubtedly one of the richest nations on earth, whereas Georgia and Armenia both have GDPs below £10,000. In terms of market capitalization, DBS is 23 times bigger than Lion Finance, and in terms of revenue, it is 14 times bigger. But Georgia and Armenia are headed in the right direction, as the IMF predicts growth of roughly 5% annually through 2030. Failures rather than expansion pose the biggest risk to the investment case in Georgian banks. The former prime minister and current de facto leader of Georgia, Bidzina Ivanishvili, may be compelled to weaken press freedom and the rule of law in order to appease his hostile northern neighbor, President Vladimir Putin of Russia, who views Georgia as falling within his "sphere of influence."

This anxiety explains the "geographic discount"the low prices Georgian banks command in comparison to their clear potential. Compared to their UK-based counterparts, Lion Finance and its rival TBC Bank trade at about 11.9 times last year's TBV, which is a premium, but still a significant discount to pre-credit crisis levels. Nonetheless, Lion Finance is expected to increase earnings and revenue by 15% this year. Despite the risks, the shares still appear appealing because they are trading at only five times projected earnings for 2026 and one-third of projected TBV. I still have an interest.