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A Simple Case for Why These Two Bank Shares May Be Bargains

There are many different ways to skin a cat when it comes to looking for bargains in the stock market. For some value investors, it could be a simple case of betting on a reversion to the mean.

Mean reversion is a simple idea that, as investment manager Dean Williams once deftly explained, “something usually happens to keep both good news and bad news from going on forever.”

In the investing arena, mean reversion can manifest itself in how below-average valuations can lead to above-average outcomes. This might have the chance of occurring for two of Singapore’s leading banks, Oversea-Chinese Banking Corp Limited (SGX: O39) and United Overseas Bank Ltd (SGX: U11).

At their current share prices, OCBC and UOB have price-to-book (PB) ratios of 1.22 and 1.19 respectively.

Chart 1 below plots the price-to-book (PB) ratios for OCBC going back to the start of 2010 and as you can see, the bank’s average PB ratio of 1.40 over the past five years is some 15% higher than its current valuation.

Chart 1, OCBC's price-to-book (PB) ratios since the start of 2010

Source: S&P Capital IQ

The next chart below, Chart 2, does the same for UOB and it shows that the bank’s average PB of 1.39 is at a nice premium (17%) over its book-multiple at the moment.

Chart 2, UOB's price-to-book (PB) ratios since the start of 2010

Source: S&P Capital IQ

The two charts also make something clear: Both banks are currently near the lower-end of their valuation ranges over the past five years and that helps set the stage for mean reversion to possibly occur.

But all that said, it’s important to keep in mind that a share’s not necessarily a bargain just because it has a lower-than-average valuation. To that point, investor Ric Dillon writes:

“On the behavioural-finance side, one of many inefficiencies comes from people anchoring on the past. People assume something is cheap, say just because it hasn’t traded at such a low valuation for five or ten years. But that doesn’t matter, what matters is what will be.”

Although OCBC and UOB have enticing valuations at the moment, investors still ought to carefully consider their future prospects before any investing decision can be made. If the two banks end up with risky loans in their portfolios in the future and start clocking losses or see their book values erode, they may still end up being expensive mistakes.

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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 writer Chong Ser Jing doesn't own shares in any companies mentioned.