Emma Wall: Hello and welcome to Morningstar. I'm Emma Wall and here with me today is Morningstar Analyst, Erin Davis.
Hello, Erin.
Erin Davis: Hello, Emma.
Wall: So we're here today to talk about the big three banking stocks. Even though banking stocks have rebounded, there's still quite a lot negative sentiments surrounding them; things like the PPI scandal, the LIBOR rate scandal, and investors are just wary. What's the first stock?
Davis: Well, our favorite U.K. banking stock right now is 
Lloyds (LLOY). Its U.K. retail banking business is excellent, regular returns, 20% returns on equity, and I think that a lot of the uncertainty around Lloyds is gradually rolling off. It's reduced its non-core asset book a lot. Things are starting to look up in Ireland, and I think that we're going to start to see the results of its strong core business coming through to the bottom line pretty soon. We're actually looking for a nominal dividend in 2013 and probably a more meaningful dividend in 2014.
Wall: As banking used to be one of the big dividend payers, and now you're saying, this is returning.
Davis: Yeah. Lloyds in particular is expecting to return about 70% of profits to shareholders in the medium term which should be really substantial. Over the last five years or so, banks have had to retain all of their earnings to build up their capital bases, which were really inadequate before the crisis.
Wall: And what's the second banking stock?
Davis: We also like Barclays (BARC) a lot. I think that it has more medium term risk, because it's not clear how profitable its investment bank or all European investment banks will really be in the medium term. But it has a good U.K. retail banking franchise, and its capital raise recently put a lot of the questions about its capital behind it. It's pretty cheap. It's trading at about 20% of tangible book value, and I think that it could easily come up another 20%.
Wall: Investors, who are wary at the market, might say, is it not cheap for a reason? Do you not think that's the case?
Davis: Oh, I think it is, and I'm not anticipating that it's going to regularly earn its 15% return on equity target, but I think that being where tangible book value is, it's a pretty modest estimate. I think that as the U.K. economy continues to improve, that it's likely to come up to that value.
Wall: So thumbs up for those two stocks. Then, what about your third?
Davis: Well, Royal Bank of Scotland (RBS), I think, has a more unclear outlook. It's clearly cheap, and that's attractive. But I think that there is a lot of risk because of the government ownership. We've clearly seen that with the creation of the bad bank. While it was nice that they didn't break up the bank, it's – they've accelerated the run-off of those non-core assets, and that means it's hard to be sure of how much value the bank is really going to be able to get out of those, because there still isn't a very good market for a lot of those things.
Moreover, it's likely to take a very big charge in the fourth quarter, which will reduce its book value further, and its equity ratios are sort of barely adequate in my opinion. They meet regulatory levels by quite a lot, but they are sub-par on average across Europe.
Wall: There's recent change in management in that company. Do you think that's positive?
Davis: Yeah. I think that the new management is really focused on turning the bank around and less focused on preserving the former management's empire. But it's difficult. Whenever there is a revolving door, it means a lot of changes and uncertainty for employees and for the bank's strategy.
Wall: So perhaps, watch the space for that one then?
Davis: Indeed.
Wall: Thank you very much, Erin.
Davis: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
