The godfather of value investing,Benjamin Graham, made it quite clear that the process of investing is nothing like speculation: An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. On the other hand, speculation is more akin to gambling, with no returnguaranteed.
With this in mind, its easy to arrive at the conclusion that banks, which rely onleverage and trading to make a living, can never be deemed true investments due to the speculative nature of their businesses. And this is the reason why Im staying away from banks likeRoyal Bank of Scotland(LSE: RBS),HSBC(LSE: HSBA) andStandard Chartered(LSE: STAN).
Complex balance sheets
Terry Smith was once one of the Citys most respected bank analysts but he now refuses to invest in the sector. Why? Well, one of Terry Smithsbasic tenets is never to invest in a business thatrequires leverage or borrowing to make an adequate return on equity. Leverage and borrowing is a key part of every modern banks business plans.
Whats more, Mr Smith notes that banks balance sheets have become almost impossible to understand, crowded with complex derivatives, the value of which no one can truly understand and can be changed in a split second. Some analysts believe that both HSBC and RBS have billions in toxic derivativesstill in hidden in their balance sheets. Unfortunately, we will not know if this statement is true or not until everything goes wrong.
Of course, theres also the quality of the assets on each banks balance sheet to consider. For example, Standard Chartered was, until recently, considered one of the best London listed banks. However, a rising number of bad loans within Asia has whacked the banks balance sheet, forcing Standard to take impairmentcharges of $1.6bn year to date and issue several profit warnings.
Mistakes of the past
Aside from the complexity of bank balance sheets, banks are still being forced to pay for their mistakes of the past. Hefty fines being levied by regulators are digging into bank reserves, denting profitability and threatening dividend payouts.
RBS, for example, announced within third quarter results a 400m provision tocover possible foreign exchange market manipulation fines.Similarly, during the third quarter HSBC set aside $1.6bn in regulatory provisions, including $378m to cover potential fines for alleged rigging in the foreign exchange markets. These provisions pushed the groups overall operating expenses 15% higher during the quarter.
Meanwhile, as well as facing a rising level of loan impairments, Standard Chartered is having to pay a constant stream of fines to regulators following lapses in the banksinternal systems and controls.
Waiting for change
For the time being it looks as if the tough regulatory environment for banks will continue and bank balance sheets arent going to get easier to understand any time soon! So, after taking these factors into account, Im going to stay away from the banking sector for the foreseeable future.
Still, before youbefore you make any trading decision I strongly advise that you take a closer look at the banking sector in general and reach your own conclusion.
To help you conduct your own analysis, our analysts here at the Motley Fool have put together thisfree reportentitled,”The Motley Fool’s Guide To Banking“.
Thefree reportguidesyou throughsix key ‘City insider’ valuation metricsfor each bank traded in London helping you to compare banks and make the best investment.
Thereport isfreeandwithout obligation. To get your copy,click here.
Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.