Backing Bradford & Bingley

Perhaps the greatest dilemma for contrarian-minded investors currently is whether bank shares offer value, or their de-ratings are a justified response to higher risks. There have been earnings downgrades and Merrill Lynch warned, in writing off nearly £4 billion equivalent of US mortgage-backed securities, the fall-out from the US housing market may not be over. UK bank shares remain nervous.
 
Yet Benjamin Graham, the 20th century American 'dean of value investing', implored investors to seek - above all - well-established businesses with demonstrated earning power, whose shares are out of favour for short-term reasons. The 'credit crunch' is certainly the story of the moment, but will be a distant

memory in two to three years' time, arguably the minimum timescale you should take when investing.
 

Bank of England caution

The Bank of England has added to the uncertainty, cautioning investors against complacency regarding the effects of the credit crunch, and Northern Rock's (NRK.L) woes have indeed exposed weaknesses in UK banking and its regulation. But Northern Rock's extent of reliance on the commercial credit markets (that have dried up) has been quite specific; despite rumour-mongering by hedge funds and others short-selling UK mortgage banks, none other has had to seek emergency funding from the central bank.
 
Bradford & Bingley (B&B) (BB-.L) is an interesting FTSE 100 company and share to follow. Its market price has progressively halved from 480p last summer to a recent low of 245p. Still under a cloud at about 280p currently, this UK mortgage bank is capitalised at £1.7 billion. Amid the despair, it is easy to overlook the substantial brand value B&B has earned over the decades, in support of a strong financial record. Undoubtedly, more bad news is liable to emerge anywhere in international banking over the months ahead, especially if Northern Rock shareholders are stung yet again, by low-priced terms in any takeover.
 

Disputing negativity

Yet experienced contrarian investors know that - eventually - clouds do lift and you can never time the turning point precisely. Only months later does it only tends to become apparent; hence an 'averaging' approach can be appropriate, buying steadily.
 
At 280p, B&B shares yield nearly 8% prospectively, on the basis of 9% annual dividend growth continuing. Yields over 5% need treating skeptically, since the stockmarket is usually exacting a high yield by depressing capital value, in order to compensate for currently high risks. So holders of B&B and other UK mortgage bank shares are implicitly disputing the negative scenario that not only will things get worse, they will continue to depress the mortgage banks' intrinsic value.
 
On a long-term view, I think it is worth looking beyond this current crisis from which the strong banks will emerge.
 
Various brokers have indeed published earnings downgrades for UK banks, but on a two-year view I believe a lot of this is already priced in. Trading commissions are brokers' lifeblood: you can expect them to jump on bandwagons when it is easy to exploit the public mood - among private and professional investors alike - to trade. Meanwhile, contrarian investors may regard such a feature of the sell-off as going too far, indeed of helping to create a turning point as long-term investors recognise value.
 
Say you take the negative view, that further downgrades are still possible, even when assuming B&B's earnings-per-share will be static henceforth. The price-earnings ratio is already below seven times the 2006 normalised figure of 41.3p per share, with the dividend covered twice by earnings. Is it so seriously at risk? I doubt it.
 

Housing fundamentals

Buying the shares rather assumes the UK housing market is unlikely to slump. Indeed, the latest population statistics - involving immigration and birth and death rates - show the UK is one of the fastest-growing globally. There is no way enough houses can be built to keep pace with our population growth. I believe this stark fact about supply and demand will provide a long-term prop, whatever near-term turbulence in credit markets and its effect on the economy and jobs.
 
The UK economic growth rate is expected to moderate from about 2.5% nearer 2.0% next year. Naturally, you should take all forecasts with a pinch of salt, but they can be worth a bit more attention than throwing over your shoulder. As Ernst & Young's Item (forecasting) Club has said, most people will not notice this difference.
 
If you want to be the ultimate bear, you could fret that a US recession will plunge the rest of the world into an abyss. But the likes of China have their own strong momentum and will overtake the US; moreover despite dire news from some US companies such as Caterpillar, others are much healthier.
 
B&B's finance director has hinted in the press, about private placements of mortgage-backed securities in order to meet the bank's funding needs since the near-closure of public markets for mortgage debt. This should help to quash the speculation that B&B is poised to go a similar way as Northern Rock. There is a strong institutional shareholder base, such as Lloyds TSB, Barclays, Legal & General and Deutsche Bank, who are likely to recognise the B&B brand is not tarnished like Northern Rock, hence it is logical to extend help.

So, although it may take time for the black cloud overhanging bank shares to lift, banks such as B&B already have an interesting risk/reward profile.
 

Price target

It is hard to set a firm share price target based on intrinsic value, but B&B's long-term average price-earnings ratio of about 10 times, and yield of about 5%, implies B&B should be trading at 400p minimum.
 
Last year, the bank made £330 million normalised pre-tax profit last year and Company REFS shows end-September forecasts looking for £344 million to £360 million this year and about £350 million to £400 million next. Although the profit outlook seems unexciting, B&B's active share buyback programme should help to support earnings-per-share.

It will be very interesting to watch how B&B and its shares progress as a test case on whether private investors stand a decent chance in FTSE 100 shares, to outwit the City view. Are such shares genuinely 'efficiently priced' or in truth, more likely to be susceptible to trends?

Go to our discussion boards on Bradford & Bingley to see what other investors are saying. Visit discussion board