How to win out over the banking crisis

Is it too early to reinvest in the financial sector? James Daley asks the experts

HSBC brought the UK banks' reporting season to a close on Monday, announcing record bad debts and record profits in the same breath. Like most of its high street peers, the credit crunch has torn strips off its bottom line in recent weeks – not least in its US division, Household, which was one of the first institutions to buckle when the sub-prime crisis started to unravel last summer.

But in spite of what can only be labelled a disaster on the other side of the Atlantic, HSBC still managed to report record overall profits of more than £12bn this week, hiking its dividend by an impressive 11 per cent. Elsewhere, the other big UK banks have done exactly the same, ratcheting up their dividends in spite of the ongoing tough conditions.

Barclays, for example, now yields around 7.5 per cent, while HBOS and the Royal Bank of Scotland are yielding almost 9 per cent. At a time when capital is scarce, handing out such large pay rises to shareholders is a strong signal of the banks' confidence that they can prevail in the current turbulent market. So could it be time to start thinking about reinvesting in Britain's banks?

Over the past eight months, the UK banking sector as a whole is down more than a third, with some individual stocks seeing their share prices chopped in two. Gary Reynolds, the chief investment officer at wealth management group Courtiers, points out that banks are as cheap as they have ever been, trading on an average of around 7.5 times their annual profits, compared to historic long-term averages of around 14 to 15 times. "The market is discounting further writedowns from sub-prime problems and also a reduction in bank earnings," he says. "Both are likely, but one cannot help but wonder whether the markdown is fully justified."

Reynolds further says that, while he still has some concerns about the UK mortgage market, banks such as Barclays, which has less than 20 per cent of its loan book accounted for by this market, look very well equipped to weather the current storm.

Chris White, the manager of Threadneedle Investments' UK Growth and Monthly Extra Income funds, agrees with Reynolds, pointing out that some of the higher quality, lower risk banks – which do not appear to have lent too much to mortgage borrowers and which do not have too great an exposure to the investment banking segment – may well be worth a look.

"This would lead us to favour Standard Chartered, Lloyds TSB and HSBC in the UK, which look best placed to come through the credit crisis with their strong capital and liquidity positions," he says. "While these banks might look more expensive than their peers on price-to-book or price/earnings ratio, the premium for quality is well worth paying."

There is already evidence that some private investors are beginning to get back into the banks. According to the stockbroker TD Waterhouse, Barclays and Royal Bank of Scotland have been their most traded stocks so far this year, while almost a quarter of all buy transactions in the week ending 13 February were accounted for by Bradford & Bingley, following a sharp fall in its shares.

But some professionals believe that it is still far too early to be getting back into the banks. While the reporting season has helped flush out a few more admissions of additional bad debts, lingering off the banks' balance sheets, there is a concern that there remains more bad news to come.

Julian Cane, the manager of the F&C Capital & Income investment trust, says that, while the central banks have been doing what they can to inject some liquidity into global credit markets, banks are still generally unwilling to lend to each other. This is because they remain nervous about the quality of assets that their competitors have on their books, and don't want to take any risks with their capital in the current unstable conditions.

Robin Geffen, the chief executive of Neptune Investment Management, agrees, adding that it's worth remembering that the banks' results have not yet been audited. Although it's rare to see any differences between companies' preliminary results and the audited figures that appear in their annual reports, the current unstable conditions mean it is more likely that the banks will be forced to reveal a bleaker picture by the auditors than they may have wanted to.

"It's much too soon to be getting back into the banks," says Geffen. "It's clear that there are ongoing problems in the US. Ben Bernanke [the head of the US Federal Reserve] has said he expects the housing situation to get worse – so anyone's that got sub-prime exposure in the UK will continue to be affected by that deterioration."

Geffen adds that, with an increasing number of hedge funds blowing up, there is a growing number of forced sellers of the bank stocks, which is also likely to drive their prices down further.

If you are looking to make some money at the hands of the credit crunch, Geffen suggests that investors take a look instead at the inter-dealer brokers, such as Icap and Tullett, which have been generating bumper profits from the current volatile markets.

For those who are determined to take the plunge and invest in the banking stocks anyway, a good way to reduce your risk is to drip feed your money into the market, buying a few shares each month. This means that if the stocks continue to fall, you will be buying some of your shares at a cheaper price.

A safer way to play the banking recovery, however, is to leave the experts to pick the stocks for you. Jupiter's Global Financial Opportunities Fund, managed by Philip Gibbs, has been one of the best performers among all British-based mutual funds over the past few years, generating a return of 154 per cent over five years. New Star's Global Financials fund, run by Guy de Blonay, has been even better, tripling investors' money over the same period. Both these funds have all but no exposure to the UK banks at the moment, and have instead been making their profits from banks in booming emerging markets, such as Asia and Eastern Europe.

Alternatively, James Davies of Chartwell Group, the financial advisers, says investors could take a look at a new structured product from Blue Sky Asset Management. The BSAM Protected Income Plan II promises a return of 10 per cent a year, and guarantees your capital on the condition that none of its portfolio of five banking stocks – HSBC, HBOS, Royal Bank of Scotland, Lloyds TSB and Barclays – fall by more than 65 per cent over the next six years. The income is guaranteed regardless. However, if any of the stocks fall by more than 65 per cent, investors' capital will be reduced by the same degree.

You may not need to take out an additional investment in the UK banks to benefit from any recovery, however. As they account for some 17 per cent of the FTSE 100 index, it is almost certain that you have some exposure to the sector if you own any regular UK funds.

To find a financial adviser in your area, visit www.unbiased.co.uk