The Banking Sector's Safest Bets

LONDON -- Bank shareholders have been enjoying booming share prices over the past 12 months.

Initially, it was the two troubled state-owned lenders, Lloyds  (LSE: LLOY  ) and RBS  (LSE: RBS  ) , and turnaround candidate Barclays  (LSE: BARC  ) that led the charge.

But more recently, the more staid HSBC  (LSE: HSBA  ) and Standard Chartered  (LSE: STAN  ) have joined the party. In fact, HSBC's rise over the past six months means its 12-month performance beats that of RBS:

Share price performance Last 6 months Last 12 months
HSBC +35% +32%
Standard Chartered +11% +4%
Barclays +79% +34%
Lloyds +74% +60%
RBS +62% +25%

Source: Google Finance.

Standard Chartered suffered its damaging encounter with the New York banking regulator last year, causing its shares to drop by a quarter overnight, but even now it's on the way up.

There are three distinct plays in the banking sector. You can pick between them depending on your attitude to risk and reward and your view of the economy.

1. Global emerging markets
HSBC and Standard Chartered are plays on global emerging markets. 90% of StanChart's income comes from developing markets, with Asia Pacific comprising 60%.

HSBC has a more globally balanced portfolio, with a quarter of its risk assets in each of Europe (including the U.K.) and North America. The rest are in emerging markets, with Asia Pacific over a third in total.

Arguably, these markets offer better prospects for organic growth, are less prone to recession, and less at risk of some form of economic catastrophe.

Certainly, the market rates the quality of these banks' earnings higher. They trade at a premium to book value, 1.3 times for HSBC and 1.5 times for StanChart. That's the sort of levels banks traded at pre-financial crisis. These are banks to own if you're relatively risk-averse.

2. European economic renaissance
Notice how all is quiet on the eurozone front? Since ECB President Mario Draghi said he would do whatever it takes to save the euro, the fundamental structural problems have been forgotten. That's been one of the two main drivers of the share price of RBS and Lloyds.

The other has been progress made by both banks' management in shedding bad assets, selling or closing underperforming businesses (or ones the EU made them sell), and bearing down on costs.

Together, that's seen both banks ratings improve. Lloyds now trades at around 0.8 times book value, RBS at 0.7. That still leaves upside scope but, with RBS having eschewed big plays in investment banking, both banks are dependent largely on the U.K. economy.

So these banks are exciting plays if you take a positive outlook on the U.K. and eurozone, with the biggest potential capital gain to be made. But be wary if thoughts of tail risk keep you awake at night.

3. Idiosyncratic turnaround
Barclays falls between the two, not as safe as HSBC and StanChart, but not as risky as Lloyds and RBS. It, too, is a turnaround situation, but one very much of its own making. Overly dependent on investment banking, a new chairman and chief executive have replaced the disgraced old guard and are introducing a new strategy and new culture.

The often-overlooked Barclaycard business makes a quarter of profits, which should make the bank less exposed to the U.K. economy, and it is less risky than the state-owned banks. It could raise capital without damaging its share price, for example, if the Bank of England forces more capital-raising on the sector.

Dividends
The greater resilience of HSBC and Standard Chartered meant they managed to keep paying dividends even in the depths of the financial crisis. Standard Chartered even kept up its record of increasing dividends, with a notional 1% increase in 2009. HSBC pared back its dividend by about 50%.

Barclays also managed to keep paying something, but the dividend per share dropped from 33p in 2007 to just 2.5 pence in 2009. Lloyds and RBS stopped paying dividends in the crash.

But that's the thing with investing in income stocks. It's not just a case of finding which companies pay the highest yield. It's a question of which can keep increasing the dividend -- at least in line with inflation -- which means looking at things like the company's prospects, dividend cover, profitability, cash flow and debt.

Fortunately, there's a lot of help out there. And to get you started, the Motley Fool's top analyst has picked his favourite stock. You can see what it is in this brand new report: "The Motley Fool's Top Income Share for 2013." It's a share I own and expect to hold for a long time. What's more, the report tells you how to access seven more Motley Fool income share picks.

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