Interactive Investor

These two cheap UK bank shares are top picks

5th January 2023 13:25

Graeme Evans from interactive investor

This year, it’s quality banks bought at a reasonable price that should rally hard, believes one City firm. Here are the two London-listed lenders that make its list.

Lloyds Banking Group (LSE:LLOY) and HSBC Holdings (LSE:HSBA) were today named as two of Europe’s top picks following a search for quality banks with capital return stories at reasonable prices.

City firm Jefferies, which sees a 20-50% upside for sector valuations, named the London-listed pair alongside heavyweights ING (EURONEXT:INGA), UBS (SIX:UBSG), BNP Paribas (EURONEXT:BNP) and three other lenders.

It believes that European banks have already been priced for a recession, adding that earnings momentum should continue even after nine consecutive quarters of upgrades due to rising interest rates and cost controls.

For Jefferies, the most attractive feature in European banking concerns the potential for significant returns of capital. This is based on expectations for the median bank in its coverage to offer an 8% yield per year in each of the next three years.

The best forecast capital return is at ING, where more than half the market capitalisation is expected to be returned to shareholders through the 2022-2024 years. NatWest Group (LSE:NWG), Lloyds and HSBC are all expected to return more than 30% of their valuations over the period.

Jefferies said: “While 2022 favoured rate-sensitive banks, we expect 2023 to favour quality banks and capital return stories at reasonable prices.”

Lloyds is among the European banks that Jefferies believes fit this description, leading to a “buy” recommendation and 59% upside to a price target of 75p.

It expects the lender’s estimated 17% return on tangible equity (ROTE) to be more appreciated by the market over the coming 12 months, meaning a material re-rating potential on the current price-to-book valuation multiple of 0.8 times.

The 17% return on equity represents an improvement of 4.3 percentage points by 2024, driven by forecasts for the net interest margin to rise from the 2.92% expected in February’s annual results to 3.29% by 2024 and a fall in the cost income ratio from 50% in 2022 to 46%.

Jefferies notes that its 2024 net interest income forecast is 8% ahead of the City consensus, with its cumulative estimate for £6 billion of share buybacks in 2022-24 some 30% higher.

On HSBC, the bank’s analysts see a 42% upside for shares to 770p as Jefferies today became the second City firm to give the Asia-focused lender a “buy” recommendation in as many days.

Jefferies regards HSBC as “catalyst rich in 2023”, reflecting the relaxation of Covid restrictions in China and Hong Kong where 36% of group assets are located.

It said: “We expect a re-opened economy to drive higher loan demand and general activity which should benefit HSBC. Hong Kong and mainland China have modestly higher net interest margins for the group, so a pick-up in loan growth in these regions should be accretive.”

The sale of HSBC’s Canada business to RBC by the end of 2023 is also likely to unlock $10 billion (£8.3 billion) of buybacks in 2023 and 2024 as well as a $4 billion special dividend (£3.3 billion).

Additionally, Jefferies sees prospects for an improvement in ROTE to 13% by 2024 from 9% in 2022, driven by a rates-led revenue performance and cost controls. On this basis, it is backing HSBC for a re-rating from the present 0.8x book value multiple to 1.2 times.

Looking across Europe, Jefferies believes current valuations fail to reflect the higher profitability than at any point in the last 15 years and the potential for return on equity to reach 10% in the 2023 financial year.

It added that the European banking index is currently trading at 7.5 times 2023 earnings, below the long-term average seen since 2005 of 11 times and near the lows touched in the 2009 general financial crisis and during the Covid pandemic in 2020.

The bank has based its expectations on a short and shallow European recession and interest rates staying higher for longer.

It sees the sector’s pre-provision profits growing 17% in 2022, then by another 11% in 2023 and by 5% in 2024. HSBC, Barclays (LSE:BARC) and NatWest are the UK banks forecast to post the strongest growth.

Jefferies added: “With recession fears and a high level of inflation, investors' concerns are concentrated on asset quality deterioration and upcoming provisions, and to what extent these could erase the net interest income benefit from higher rates.

“Our view remains that provisions will rise in the coming years, but not surge. We also think that the pre provision build-up will be much higher than the additional provisions, meaning we expect post provision profit to grow further at European banks.”

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