Disclosure: Roland owns shares of Royal Bank of Scotland Group.
Today I’m going to look at what I intend will be my final stock purchase of 2016.
Despite its apparent potential as a distressed asset play, I’ve stayed away from Royal Bank of Scotland Group plc (LON:RBS) until now.
In this post, I’ll explain why I’ve changed my mind and added shares of the state-controlled bank to my value portfolio, paying 226p per share.
Catalysts for a turnaround?
I believe RBS could be approaching a turning point in its recovery. This is a topic I touched on in a recent article for the Motley Fool, where I highlighted three potential catalysts for RBS shares.
Costly legal woes: The recent stress test failure was unfortunate, but the criteria for the test were very severe and also served to highlight how much stronger UK banks are now than they were five years ago. As far as I can tell, RBS only failed because it faces a potential multi-billion dollar settlement relating to mis-selling allegations in the US.
I expect this case to be resolved in 2017. It may prove to be a painful one-off hit — analysts are forecasting a fine of up to $12bn — but it will pass, leaving RBS in a better position to move forwards.
A profitable core: The bank’s core operations generated an adjusted return on tangible equity of 12% during the first nine months of the year. Given that the group-wide figure was -0.6%, it seems to be that if the bank can shed enough of its bad assets, underlying profits could rise sharply.
Government action: By all accounts, Chancellor Phillip Hammond is both pragmatic and decisive. He may well decide to start selling the government’s stake in RBS without waiting for some arbitrary and contrived breakeven point to be reached. This could even happen in 2017.
I believe that a clear decision to return RBS to private ownership would be well-received by the market, as it would resolve uncertainty about the bank’s control over its future strategy.
RBS shares continue to trade at a discount of about 33% to their tangible net asset value of 338p. This implies that the market doesn’t believe these assets are of sufficient quality or profitability to justify a higher valuation. It’s certainly true that RBS’s tangible net asset value has fallen significantly over the last five years as a result of impairments and the discounted sale of non-core assets.
I suspect this process may have further to run. But I don’t think it’s going to eliminate the value opportunity which lies between the current share price of 225p and the bank’s tangible net asset value of 338p.
Should I set a price target?
I believe the outlook for RBS is gradually improving. The bank’s net interest margin has been stable this year, while the adjusted cost: income ratio has fallen slightly. Bad debt levels (known as Risk Elements In Lending, or REIL) were down to 3.8% of gross customer loans at the end of September. That’s still relatively high, but is an improvement on 4.5% one year earlier.
Lots of the bank’s key performance metrics seem to point to progress, in my opinion. However, I’m not going to pretend that I’m able to undertake a meaningful and precise valuation of this business. There’s no way I could do this — big banks are far too complicated and opaque for that.
Instead, I’m just going to stick to time-honoured value investing principles and buy shares at what appears to me to be a discount to their net asset value. Such asset plays can be risky and slow to come good. I may end up with egg on my face, but that’s a risk I’m prepared to take.
For what it’s worth (not much) RBS currently trades on a 2016 forecast P/E of 16.3, falling to a P/E of 13.9 in 2017. I believe that both earnings and the share price are likely to rise significantly over the next few years.
I’ve added RBS to my value portfolio at 226p.
Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.