Stockwatch: Brexit fear is chance to buy this bank

Do accumulated losses of £50 billion imply Royal Bank of Scotland has reached the stage of "contrarian buy"? The top three directors reckon so, buying just shy of £1 million worth of shares at about 223p: chief executive Ross McEwan has risked £446,000, chief financial officer Ewen Stevenson £446,400 and chairman Howard Davies £88,400.

Such news came after I weighed up RBS and wrote this piece, thereby underlining a fundamentals-driven investment case for the bank.

Its 2015 prelims quite contrast with those from Lloyds Banking Group, which surprised with a special dividend policy that boosted its shares by 20% in two days. RBS doesn't expect to pay a dividend in 2016, hence its shares have fallen nearly 10% to 223p.

And the five-year chart looks pretty awful, but the shares did bounce from 225p to 260p earlier in February, as if finding support. Most likely this was because key financials (see table below) imply profits will recover by over £5 billion, much like Lloyds, which bounced back into normalised pre-tax profit of £8 billion.

Brexit risks are in focus, yet fears are likely to get overdone as short sellers accentuate the dropsA circa 45% discount to net tangible assets - with the share price currently about 222p - offers a sizeable buffer for what exceptional charges remain. The consensus dividend forecasts would have been made before the results and are premature, but, unless the UK economy deteriorates, e.g. with near-term disruption from a Brexit, the risk/reward profile is starting to look attractive for patient buyers.

European banks sold off heavily

As some banks trade near 20-year lows amid fears of a new contagion risk, RBS is back at 2009 levels once adjusted for consolidation. A mix of factors have driven this sell-off, such as banks' exposure to the oil & gas industry and high yield bonds - whose spreads allegedly imply a 70% risk of recession - and negative interest rate policies gaining support among central banks.

Lord King, the former Bank of England governor who stepped down in 2013, is grabbing attention with a book launch alleging the world is on the cusp of another crash: "Bankers and regulators have colluded in a self-defeating spiral of complexity". Pot, kettle and black come to mind.

Underlying balance sheets show RBS is the best-capitalised of the major UK banksChinese currency issues are also back in the frame as its central bank guides the yuan lower, despite political rhetoric that this isn't about making Chinese exports more competitive.

And "Brexit" risks are very much in focus for potential disruption to the UK economy and sterling. As George Osborne prepares a likely disciplinarian budget, his references to "storm clouds" intone a classic bearish story for bank shares, as leading indicators of the economy.

Yet fears are likely to get overdone as short sellers accentuate the drops. Various major banks are fighting back with the resolve to pursue dividend pay-outs. While Lloyds has seized attention this way, it's worth bearing in mind that RBS's own strengths should enable dividends to resume after the first quarter of 2017 (according to the latest guidance).

Turnaround strengthens balance sheet

While Lloyds' shares jumped sharply and RBS's fell, their underlying balance sheets - which bear on dividend capability - show that RBS is the best-capitalised of the major UK banks with a 15.5% Common Equity Tier 1 (CET1) ratio - i.e. the bank's core equity capital versus its risk-weighted assets.

RBS needs to focus perceptions on personal, business and commercial banking, not dirt from the investment bank and toxic assetsThis compares with a 13% CET1 for Lloyds, as the market reacts to rising expectations for dividend pay-outs. Yet this key test of a bank's financial health shows that RBS is broadly on course to resume dividends.

Meanwhile, an end-2015 net tangible asset value (NTAV) of 403p per share should absorb continued restructuring charges, disposal losses and fines. Further large settlement costs are expected in relation to US mortgage securities (whenever this might happen) and the divestment of its Williams & Glyn lending bank.

However, trading on a 45% discount to NTAV is substantial and compares with Lloyds'13% premium. A leverage ratio of 5.6% is also satisfactory and represents the relationship between a bank's core capital and total assets.

The 2015 results were mixed. Revenue fell 15% to £12.9 billion due to its investment bank downsizing and risky asset disposal, while adjusted operating profit is 28% lower at £4.4 billion. Such an "adjustment" sees through fines, litigation and restructuring costs but includes certain aspects of lower income and "bad bank" legacy asset disposals.

In the months ahead, RBS may be seen as a prime long/short trade on the EU referendumThe RBS story still needs to be cleaner so that perception can focus on personal, business and commercial banking without dirt from the investment bank and remaining toxic assets. Encouragingly, the group's adjusted return on equity was 11.0% compared with minus 1.5% in 2014, underpinned by mortgage improvements. Net new lending reached £9.3 billion, albeit at lower overall margins.

Adjusted operating profit from UK personal and business banking was broadly stable at £2,169 million, while commercial banking slipped 6% to £1,384 million amid margin pressure and asset sales. With 90% of revenue derived from the UK and Ireland, the chief risk is that economic slowdown - anticipated or actual - will undermine these divisions. Otherwise, the Ulster Bank saw operating profit down 45% to £264 million, the Investment Bank made a £55 million loss and Capital Resolution ("bad bank") a £412 million loss.

Much like Lloyds

Their stock performances have been bi-polar in recent days, yet the core of both offer sound cash generative businesses as the detritus of 2008 is removed. Royal Bank of Scotland, NatWest and Coutts are strong brands, if falling short of Warren Buffett's sense of "franchise" - i.e. economic moats and freedom to price. RBS is behind the curve compared to Lloyds, but it can get to a similar place. Both turnarounds are interesting, with near-term sentiment swinging to Lloyds in the search for yield.

£50 billion accumulated losses since the 2008 crisis will mitigate taxation for a very long timeIn the months ahead, RBS may be seen as a prime long/short trade on the European Union referendum and we will see whether George Osborne's drive for a balanced budget (revenue equal to expenditure) is the appropriate policy for the "storm clouds" he has identified.

If you are pessimistic as to Brexit and the UK economy then avoid bank shares, but my base case is for an overall 'Remain' vote that would lift negative sentiment, hence anxiety in the months ahead looks opportune to accumulate.

RBS should now be near the end of big headline losses, given the bulk of restructuring is due to be completed by end-2016, and - unless the market turns seriously risk-averse - then it will start to price in the prospect of sunnier uplands. Remember also: £50 billion accumulated losses since the 2008 crisis will mitigate taxation for a very long time.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.