Banks feature prominently in three of the W4.0 strategies and are naturally a focus of attention for me and the W4.0 members following them. Although there is a lot of information and analysis available on the W4.0 site, which explains why I have included these positions in the strategies, I wanted to give an update on:

• Why I believe the sector is still undervalued,
• Why UK banks are particularly appealing,
• And what I think the future holds for the sector.

There are several banks in each of the strategies, and all are different, but there are characteristics of the businesses that are common to all of them, and I am focused on these features in this note. It is also important to note that this analysis is my opinion, and like so many things in financial markets, it is not an observable fact.

Before giving you that opinion, I should note that this core question (why are UK banks so cheap?) is one that many have opined on over the last few years, including the Governor of the Bank of England in a speech he gave in early 2024. Interestingly, although he did say that two frequently repeated explanations, higher and different regulatory requirements were not the reason, and I agree with him on that, he couldn’t answer, and neither could his 60 assistant speech writers, why UK banks trade below book value and the valuations of peers in other markets.

Here’s my view.

In some respects, the undervaluation of UK banks relative to their history and to international peers reflects the wider and prolonged valuation discount that has affected the UK market for many years. Indeed, given this wider market issue, it would be odd if the UK banking sector wasn’t also cheap.

I have written before about the structural problems that have confronted the UK equity market for the last two decades. It is a sad story of neglect and self-harm driven in large part by regulatory changes. However, the good news is that these headwinds, which have been an ever-present challenge for UK equity performance for the last twenty years, are now at an end, or very nearly.

On this point I was interested to read that Scottish Widows, which manages £72bn of workplace pension assets, announced today that it will be reducing its UK equity exposure from 12% to 3% in its highest growth, default portfolio, and from 4% to 1% in its lower risk portfolio, “bringing it more in-line with its peers' UK equity allocations”. Aside from the obvious point that once weightings are as low as this, there is nothing left to sell, this does illustrate how far UK institutional selling of the UK equity market has gone. According to the think tank New Financial, in 2000, UK pension funds had close to 50% of their assets in UK equities, and by 2024, they had just 4%.

To illustrate just how unusual this is, I thought I should show this table sourced from the Capital Markets Industry Task Force:

The table clearly shows how much of an outlier the UK pension industry is. It’s no wonder that, against this backdrop of relentless and massive domestic institutional selling of the UK equity market, its performance has suffered so badly over many years.

This prolonged selling pressure and the consequent underperformance has created valuation anomalies across the UK equity market and, naturally, in the banking sector.

UK listed banks, whether domestic economy focused or global economy focused (HSBC and Standard Chartered) all share this valuation discount, to varying degrees, by reference to normal valuation metrics such as PE ratio and price to book but also in comparison individual bank ROEs, which typically compare very favourably with banks listed in other developed economy markets.

Analysts in the sector tend to solve for this price-to-book valuation anomaly by assuming that UK banks must have a much higher cost of equity than peers in similar economies (see aside below). In some cases, this argument has some credibility by reference to lower risk-free rates, for example, across Europe where ten-year yields are typically more than 100bps lower than in the UK. But this argument breaks down in comparison with banks in the US. In the US, ten-year yields are only 18bps lower than in the UK, so the cost of equity for banks should be broadly similar, but typical price-to-book ratios for US banks with similar ROEs to their UK peers are 1.5 to nearly 2.0x higher.

I don’t really buy this risk-free rate argument, as you can probably tell, nor the COE explanation. Ten-year yields are significantly lower in Europe because the ECB has been much more aggressive with rate cuts than the Bank of England, and as a consequence, is near the end of its rate-cutting cycle, whilst the Bank of England is much closer to the start. Ultimately, with similar long-run inflation and growth characteristics, there is no clear fundamental reason why UK banks should face a higher cost of equity than their EU peers.

I believe the more credible explanation is that banks, like so much of the UK equity market, are structurally undervalued because they have been subjected to relentless selling for so long. This selling has driven them and the broader market to an unwarranted, deep discount both to their history and to their peers, to which domestic and global investors have become increasingly accustomed.

In my opinion, attempts to explain this by referring to traditional valuation techniques are bogus and a form of ex-post rationalisation.

It’s also worth mentioning that UK banks have performed very well over the last year, but they still look profoundly undervalued. My guess is that as UK interest rates continue to fall, the economy continues to confound a bearish consensus, and bank profits, earnings, dividends, and buybacks continue to grow, this valuation anomaly will naturally correct. Their valuations will lose the discount that has blighted the sector and the broader market for so long.

This explanation might seem like an incredibly simple answer to this straightforward question. Many might be tempted in seeking to answer it, like the Governor of the Bank of England, to indulge in the arcane analysis of bank balance sheets, P&Ls, capital ratios, relative regulation, competition, taxation, even comparative macro-economic analysis, and in the past I have been guilty of this, but in my experience this process has never got even close to providing a satisfactory answer to this question.

Sometimes the best answers are also the simplest.

An aside

The cost of equity is a theoretical concept equating to the return investors require or expect to receive from investing in a company’s shares. It is essentially the opportunity cost of investing in that share versus alternatives. The ROE is net income divided by average shareholder equity.

The argument here is that the price-to-book ratio should have some relationship to the margin of the return on equity over the cost of equity. For example, for a bank with a 12% ROE and a 12% COE, the argument might be that the price to book should approximate to 1x, (ignoring growth and future changes in these ratios) whereas a bank with a 12% ROE and an 8% COE, again assuming no change, might trade on 1.5X book.

My observation from decades of analysing bank valuations is that this type of analysis is interesting but not determinative.

In my experience, analysts decide what the cost of equity is by starting with the ROE, looking at the price to book and then solving for the COE. In other words, the idea that an analyst might know what the shareholders of a bank, or any other company, for that matter, require or expect to receive for investing in a company’s shares is theoretically interesting but not provable. (I have yet to meet an analyst who actually asked a company’s shareholders what return they expected. If they did, I suspect that there would be a wide range of answers and hence not one COE. I suspect that it would also change dramatically over time.)