It looks like we’re going to see continued volatility in the markets, particularly over the quieter summer months, so I’ve once again adopted a defensive stance and selected this week’s best share tip and ‘gamble of the week’ for their solid returns and low valuations. Watching England play in the World Cup provides enough emotional stress without having to worry about the stockmarket as well!
Royal Bank of Scotland (RBS: 1,744p), tipped as a BUY by Lehman Brothers and WestLB
What a stable of top-quality brands: NatWest, Direct Line, Coutts (the bank used by the Royal family), Citizens Financial in the US and also a 5% stake in Bank of China. With a £55bn market cap, RBS is the second-largest bank in Europe and ranks fifth globally. It has around 20 million customers and 2,250 branches in the UK and it generated £7.9bn of pre-tax profits in 2005. This is a monster organisation with plenty of bite, as demonstrated by its past voracious acquisition strategy.
RBS is a diversified financial services group, both in terms of sectors and geographical reach. Clearly, its performance depends on the health of the UK and US economies, yet its spread of interests gives it resilience in the face of stockmarket turmoil. On top of these defensive qualities, RBS hopes to leverage its 5% stake in Bank of China. CEO Sir Fred Goodwin believes it will create opportunities in the Chinese credit card and general insurance sectors. Chinese rules on the role of overseas banks in its domestic financial-services industry will be relaxed in 2007. In the coming years, China is expected to change rapidly from a cash to a credit society, thus providing huge upside for onshore banks.
Out of all the UK banks, I would rate RBS as my top pick. Research analysts forecast 2006 pre-tax profits of £8.8bn (11% growth), generating an earnings per share (EPS) and dividend of 188p and 81p respectively. At 1,744p, the shares trade on a forward p/e of only 9.2 and offer a whopping 4.7% yield, which is 2.3 times covered. In terms of 2006 p/e multiples, RBS is one of the lowest rated of the UK banks. Most of its peer group trades within the ten-12 p/e range.
Why the valuation discount? There are three principal issues, all of which have now been largely resolved. Since 2002, RBS’s EPS has grown on average by only 5.5% a year, but this is now set to change. It gained a reputation as being an acquisition animal, and there were concerns that a huge purchase could substantially dilute earnings. Now it appears that’s off the agenda, with the emphasis being on organic growth.
Last year, Sir Fred Goodwin was labelled as a megalomaniac and criticism was heaped on the board for building a new £350m Edinburgh head office. Improving results will silence these dissenting voices.
A bank the size of an RBS, with its premium brands, should be able to grow at least as fast as the industry, if not slightly quicker. Assuming the board can deliver, then the existing 20% discount to the sector is overdone, and the stock deserves a re-rating. In my opinion, RBS is a well-managed business with strong brands that delivers predictable returns in uncertain times.
Recommendation: BUY at 1,744p. One to tuck away for the long term
Paul Hill’s personal portfolio has gone up by 483% over the last five years. To find out mroe about his own specialist share-tipping service, click on the link below: