Making money from the bank share price cycle

Walter Bagehot, founder of the world's most influential and authoritative publication, The Economist, once stated that banking was magic, and so truly it has proved to be in Britain's case. The biggest banking education of all is not the acquisition of academic qualifications, though these may be important, but the actual making of money out of money as an objective of self-fulfilment.

Banking requires the combination of several qualities of culture and character to be a success. This is the lesson taught by HSBC, which became the top bank in the world by assets, even surpassing Citigroup. Banking has become the first seriously globalised industry and its trade cycle is global.

This particular phenomenon is the key to understanding the success of the HSBC share price and the relative decline of that of Lloyds TSB in the past ten years.

Investors develop what might be called 'risk intelligence', a psychological state of mind, which is receiving increasing attention from economic theorists. This 'risk intelligence' enables them to profit from a knowledge of the trade cycle but may also be combined with taking contrarian decisions.

The bank share price cycle, currently at the top, was demonstrated undisputedly in the past week after the world's leading banks published their half-yearly results. The greatest proof of this situation was provided by HSBC.

It is indeed a paradoxical situation where two powerful bank analysts like Jonathan Ford and Mike Verdin in the Sunday Telegraph point out explicitly that the best chance among British banks of an appreciation in share price and dividend payout lay in Lloyds.

A universally successful bank like HSBC has known how to ride with enormous profit the share price cycle of the present globalised banking system. Banks are at the top of the cycle as the published results of HBOS, HSBO, Lloyds and HSBC demonstrate, but that does not mean that all these banks offer equal chances of share appreciation.

The benefit to the investor coming from HSBC during these last two and a half years has been small indeed. There has been a declining dividend payout. This was a reflection of the enormous strength of HSBC's financial ratios rather than of their weakness.

Investors have stuck to HSBC hoping to see a repeat in the great leap forward of its share, which happened after it became clear that it would not be effected by the communist take-over of Hong Kong.

Share appreciation

The prospective appreciation of a company's share price depends greatly on its dividend policy. The British banking system has an oligopolistic structure, and this means that although banks like Barclays and HSBC satisfy all the credentials for banking greatness they will not necessarily transmit their wealth to their shareholders.

A psychic income will be transferred because being a shareholder in a bank like Barclays and HSBC is a matter of pride, and an investment for one's children. If investors were to look for immediate returns as dividends and possibly a share price rise, they had better look at Lloyds TSB, which seems to have learned the bitter lesson from its august position almost a decade ago. I will not repeat the story of its New Zealand banking adventure.

These dreams came to nothing. It was HSBC that built up an international presence in the last 30 years and this has been consolidated in the past decade. HSBC does it by carrying out a conservative balance sheet policy and by paying a declining dividend.

It was contrarian in the making of its famous big acquisitions, and even in its small ones, of which we have had a far from unpleasant experience. Many Maltese have been shown the other side of the coin by HSBC.

The taste of a pudding is in its eating. Mid-Med Bank was administered with bureaucratic laxity. HSBC improved the cost-income ratio significantly within months of taking over. I have a letter on Mid-Med stationery from Tom Robson to that effect.

HSBC and Lloyds TSB form a great, and possibly entertaining contrast. The agile investor might be presented by a great opportunity. Lloyds TSB has been paying out a massive dividend for the past four years. Some analysts have more than hinted that it could not afford it.

This has been the joy and pleasure of those who followed the Lloyds TSB recommendation of Fortune magazine. This dividend at 6.3 towered above the banking sector's 3.8 yield. It was an answer last week to oligopolistic collusion in dividend payout by the British banking system.

Oligopolistic competition

British banking faces the famous kinked demand curve of oligopolistic competition, well explained in most A level economics textbooks. Lloyds TSB has broken the tacit agreement on the great British banks to pay miserly dividends. The rigours of the kinked demand curve would have it that Lloyds TSB would not have succeeded to break the oligopolistic power of the British banking system for any considerable period of time.

It managed to do so for four years. This is indeed remarkable.

Lloyds and HSBC are both at the top of the world banking cycle. There are great days ahead for HSBC as regards banking prestige both for itself and those who invest in it. As regards Lloyds TSB the small investor wanting a quick dividend return had better ask why this great bank, which has made only one big mistake and that is the globalisation one, has been able to pay such a massive dividend while still remaining a high and desirable prey for such a bank as the American bank Wells Fargo.

Last week's massive profit success of Barclays and HSBC (25 per cent increase in profits) has propelled them into a new dimension. They have for its time being outdone by the likes of Deutsche Bank which has registered a humiliating loss in its money trading.

They seem to be seized by fit of hubris, which is the Greek tragedy word for excessive pride. They now have a world banking clientele, and the British investor has obviously become a secondary consideration. Barclays is deriving 50 per cent of its profit from outside the UK.

The money games of Barclays and HSBC are not for widows and orphans. They are probably great fun for anybody who has the nerve to see HSBC trying to outdo Wall Street in its race for world financial supremacy.

It will probably be paying unspectacular dividends for their children. There is price for being a shareholder in what may be in a little time the world's two greatest banks. Can the small investor or the pensioner pay such a price?

This article is not intended as investment advice, but aims to help produce an investment culture. John Azzopardi Vella has promoted the Malta Development fund and advised S&P. He is currently research economist of DBR Investments Ltd. E-mail: johnazzopardivella@hotmail.com.