Financial services: buy the stock, not the products

Jenne Mannion says there may be a better home for many savers' and investors' money

Financial services companies promise savers, investors and borrowers the earth, but their primary goal is to deliver value for their own shareholders, rather than customers. On that basis, are their shares a better home for your money than their products?

Britain's banking sector may be a hotbed of takeover speculation - rumours in recent weeks have linked Alliance & Leicester with foreign bidders - but bank shares have lagged the broader UK stock market in the past year. And they face further headwinds given that a decline in consumer borrowing and rising bad debts will negatively affect profitability.

But investment professionals say this is not a doomsday scenario and there are plenty of good opportunities to be found for selective stock pickers.

Over the past 12 months, the UK banking sector has posted a 25 per cent gain, compared to the broader FTSE All Share return of 32 per cent. This relatively weak performance from the banking sector arose despite a healthy reporting season earlier in the year where many of the banks unveiled record dividend and profit growth.

Richard Dunbar, manager of the Scottish Widows Investment Partnership (Swip) Global Financials fund, says with the investment hotspot in the last year being oil and mining companies, banks have been largely left in the shadows by investors.

Mike Felton, manager of the M&G UK Select fund, adds that large banks have also suffered because of their size. "The sweet spot within the stock market has been the mid caps, particularly because of the abundance of takeover activity," he says. "Many of the banks are so large - nobody is going to be bidding for HSBC or Royal Bank of Scotland - but this lack of popularity means their valuations are cheap relative to their growth prospects and certain banks look very attractive."

Felton cites HSBC and Royal Bank of Scotland as promising. "Both are attractively valued yet have strong growth prospects. Furthermore, both have high dividend yields of more than 4 per cent, and strong dividend growth."

Jamie Hooper, manager of the F&C UK Equity fund says although profitability among banks has been strong in recent years, there are clouds on the horizon for two key reasons."A major driver of profitability has been strong consumer lending but there are signs that is slowing. Meanwhile, bad debts have not yet peaked. These could get worse in the current economic environment, though I do not expect a catastrophic or disastrous scenario," he says.

Hooper's F&C UK Equity fund has lower than market weighting to banks, but there are some select stocks in which he holds big positions. These include Barclays, which owns a large investment bank in the UK. Investment banks are benefiting from the increased business gained amid the flurry of merger and acquisition activity in the stock market.

Hooper also likes Standard Chartered, an Asian-focused bank. He says Standard Chartered is highly exposed to strong growth potential in emerging markets. "There is a strong possibility that Standard Chartered could surprise on the upside in terms of profits. It is also considered a prime takeover target," he adds. Royal Bank of Scotland is also a key holding for Dunbar at Swip, along with HBOS.

Looking beyond the large banks, Dunbar cites the mortgage bank Northern Rock, which is benefiting from strong mortgage demand in the UK.

Hooper says there are three scenarios which would result in banking stocks starting to outperform within the UK stock market. The first is if there is any significant merger and acquisition activity among some of the banks, which would provide a fillip for the whole sector.

Second, if UK interest rates started to fall, this would reduce the pressure on borrowing and subsequently result in a lower level of bad debts.

"Finally, if the UK equity market were to share a short-term correction, bigger banks such as HSBC could be seen as a safe haven, which would encourage investors to buy these shares," he says.

While the outlook for banks is mixed, more optimism surrounds other financial stocks. The life assurance sector within the FTSE All Share has posted a 40 per cent gain over the past 12 months while general financials (which includes asset managers and stockbrokers) have advanced by 75 per cent.

The three year bull market in equities has certainly boosted the fortunes of these companies by increasing the value of their assets under management and enticing investors back into the stock market. But they are also benefiting from a trend whereby investors are spending less and saving more.

Life assurance companies had their problems earlier in the millennium due to poor solvency ratios, meaning they did not have adequate low-risk assets to cover their liabilities, resulting in forced selling of equities. However, the picture is now far healthier. The three year bull market in equities has helped to reverse the situation and assets have grown strongly since.

Increased publicity on the importance of individuals saving for their own pensions has also been beneficial and life insurance companies are benefiting from strong new business flows, Dunbar adds.

Meanwhile, Aviva's bid for Prudential, although rejected, has further stimulated interest in a market awash with merger and acquisition stories. Felton believes there could be further consolidation in the sector.

Tips from the experts

* Tom McGrath, Miton Optimal

McGrath tips Iimia, an investment manager. He has bought shares in the parent company, which are listed on the Alternative Investment Market. "This gives me exposure to all of the group's investment trust products," he says. "They have a very good, proven management team and I expect they can continue to do well. Provided the investment trust products perform well, as I expect them to, so too will the share price of the company."

* Katrina Preston, Bridgewell

Preston says following strong interim results from Aberdeen Asset Management there is scope for further upgrades at the fund manager given the higher than expected growth in assets under management. Meanwhile, increasing demand for global equities and socially responsible investment products provided greater diversification away from Aberdeen's core Asia Pacific and global emerging markets products. Also, the assets retained following the merger with Deutsche Asset Management were higher than anticipated. She expects further strong growth in assets under management, thus leading to higher profitability.

* Jane Coffey, Royal London Asset Management

Coffey says the UK banking sector as a whole has become unloved and that Royal Bank of Scotland has been unfairly de-rated. RBS trades on an attractive price earnings ratio of nine times earnings and yields above four per cent. She says following the acquisition of NatWest in the UK and Capital One in the US there was some pressure on capital ratios. However, given recent strong cash generation this has now also eased. Although RBS still has international ambitions, recent management statements have ruled out another major acquisition and Coffey expects to see a continuation of recovery in the business, a growing dividend and share buy backs.