Financial companies have long represented the core investment for many private investors. Historically, stocks in the banking sector have offered above-average dividend yields and have been viewed as providing a lower risk than many other sectors of the market. Although there have been occasional hiccups due to the emergence of bad-debt crises, banking stocks have, in general, delivered healthy long-term returns to their shareholders.
Financial stocks have, for a long time, accounted for a large proportion of the Irish equity market and, therefore, a bull market in the overall index will require performance from the financials if it is to be sustained. This has again been evident in recent months as a strong recovery in financials, which still account for 27 per cent of ISEQ total market capitalisation, have driven the ISEQ to all-time highs.
The recent re-emergence of bid activity in the UK banking sector will, therefore, be watched with keen interest by Irish investors. Abbey National, the large UK mortgage provider, confirmed that it was in preliminary discussions with Bank of Scotland regarding a possible merger.
Investors will recall that Bank of Scotland initiated a bid for NatWest Bank, only to be trumped by its larger rival, the Royal Bank of Scotland.
The share prices of UK bank stocks have been rising steadily in recent weeks and the announcement regarding merger discussions added a further fillip to share prices. While the Bank of Scotland statement appeared to discount Abbey National's approach, it is early days. Indeed, the likelihood that another bank, such as Lloyds/TSB, will enter the fray seems high.
Whatever the eventual outcome, it seems certain that the process of consolidation in the UK financial sector has a long way to go.
This heightened corporate activity in the UK financial sector is likely to underpin the recent strength in Irish financials. Despite continuing share price gains, Irish banks are valued at a modest discount to their UK counterparts. For example, Bank of Ireland is trading on a price-earnings ratio (PER) of 10.3 compared with 11 for Abbey National and 12.1 for Bank of Scotland. AIB is on a PER of 10.8, whereas Llyods/TSB is trading on a PER of 12.6. Arguably, the faster rate of growth in the Irish banks' domestic market should warrant a premium rating.
There is also the possibility that another high-profile UK bank merger or takeover will lead to speculation of a possible takeover of one of the large Irish financial stocks. However, investors should probably treat such speculation with a grain of salt, given that the Irish banking market is far more concentrated than its UK counterpart. Therefore, any takeover activity in the Irish market would have to involve an overseas institution.
Experience to date in Europe has been that the majority of banking mergers and acquisitions have occurred within national boundaries. Certainly, the three large Irish quoted stocks - AIB, Bank of Ireland and Irish Life & Permanent - are keen to secure add-on acquisitions in the domestic market to expand their market share. However, the prospects of a merger or takeover involving any two of these three companies seems remote, given the increase in market concentration that would ensue.
Fortunately for investors, the absence of large-scale merger activity need not be a deterrent to further investment in Irish financial stocks. The financial sector's current relatively low valuations, combined with solid growth prospects, should be sufficient to sustain the current forward momentum in share prices.
