How To Make Money From Banks

The Motley FoolThere was a time when banks could do no wrong. Everything they touched would somehow turn to gold.

Today, however, many banks can do no right. At almost every turn they are confronted by regulators ready impose another fine, slap on an additional penalty or enact another piece of legislation to clip their wings.

The thing to remember about banks is that they are heavily exposed to the wider economy. Consequently, when times are good, they can make extraordinary amounts of money. And they did.

However when times are bad, they can rack up massive losses because they are heavily exposed to the wider economy. And guess what? They did that in spades too. That is the price that banks are forced to pay and the cross that investors have to bear when we invest in these financial institutions.

Heavyweight banks

Currently in Singapore, banks make up around a third of the Straits Times Index (SGX: ^STI). DBS Holdings (SGX: D05) and Oversea-Chinese Banking Corporation (SSX: O39) account for around 11% of the index, while United Overseas Bank (SGX: U11) makes up about 9% of the benchmark index.

The point about the weighting of banks is that it can be quite difficult to avoid investing in banks even if you don’t invest in them directly.

As a result of their sheer size and market value you are inevitably be exposed to banks if you, say, invest through a stock market index tracker that mimics the Straits Times Index. Even if you don’t invest in equities directly, it is quite possible that your pension fund might be exposed to bank shares.

However, if you do want to invest in banks directly, it is important to bear in mind a couple things.

Firstly, a bank’s financial statement can be quite opaque. I can be so impervious that some bank executives might not always know what is going on from day to day. In many ways a bank is not dissimilar to a mysterious black box. Money goes in one end and (hopefully) money comes out the other. But what goes on inside the box can be almost unfathomable.

The second thing to bear in mind is that diversification when investing is vital. A portfolio packed full of banking stocks, even if they are different banks from different countries, is not diversifying at all. That is because you would be exposed to just one sector – banks.

However, if banks form only a small part of our portfolio, then your investing returns are unlikely to be too severely damaged even if, say, just one or two banks were to perform badly.

Valuation matters

When looking at prospective bank shares, the dividend yield might be a good place to start your investigation. Currently, Singapore’s big three banks sport historic dividend yields of around 3%. Both DBS and OCBC have historic yields of about 3.3%. UOB’s historic yield is a tad lower – it’s 2.9%. The payouts were adequately covered by profits.

In terms of valuations, the three banks are much of a muchness. All three are valued at between 12 and 13 times historic profits.

From a shareholder’s perspective, Oversea-Chinese Banking Corporation is perhaps quite eye-catching in terms of its total return. The total return is made up of two parts – capital appreciation and reinvested dividends.

Over the last ten years, OCBC has delivered a total return of 199%, which equates to a return of around 12% a year. Put another way, S$10,000 invested in OCBC in 2003 would be worth around S$31,000 today.

By comparison, the same amount invested in DBS ten years ago would be worth S$20,800 today. A similar investment in UOB would be worth about S$24,000 now.

It is worth reiterating that we do not need to invest in banks directly to gain exposure to the banking sector. An index tracker, such as the SPDR Straits Times Index ETF (SGX: ES3), would probably provide enough exposure. That said, it is also worth stressing again that banks could be a geared play on the wider economy. So the question is this: Do you think that the worst is over for the global economy and that it could start growing again?

A version of this article first appeared in the Independent on Sunday.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.