How I’d choose bank shares to buy

With many banks reporting their annual results this month, I have been considering the role of banks in my portfolio. I have been thinking about adding more UK bank shares to it – here is how I would go about selecting them.

Domestic strength

Lloyds and NatWest both offer me strong exposure to the UK business and retail banking market. I see that as their strength, but also weakness. It can be a lucrative market – NatWest recently reported a full-year profit of almost £3bn. But both banks’ reliance on the UK market can mean that their businesses suffer badly if the UK economy falters. For example, as the country’s leading mortgage lender, Lloyds can do well when the housing market performs strongly but any increase in default rates could also hurt its profitability.

Barclays has a strong UK retail banking operation too, but in addition it has a sizeable investment bank with global operations. So Barclays reduces the risk of overconcentration in a single market. But it does it by operating in investment banking, an area notorious for dramatic swings in profitability. That adds some volatility to Barclays when it comes to consistency of results, but I also think it adds the prospect of strong profits when its investment banking division performs well. In its half-year results, for example, the bank reported £11.3bn of income. £6.6bn of that came from the international corporate and investment banking operation.

Overseas focus

Barclays has an international operation but also a big UK one. Competitor HSBC has a UK retail banking set-up too, but its main focus is Asia. Rival Standard Chartered, although based in the UK, is even more focussed on developing markets especially in Asia and Africa.

I think both of these banks can offer me exposure to the strong growth prospects in emerging economies. That could help make them profitable both now and in the future. But emerging markets also carry large risks, including complex political risks. That is reflected in the annual results HSBC released today, in which the company pointed to the risks of uncertainty in the Chinese real estate sector.

Smaller bank shares

I could also consider a smaller listed bank, such as Metro Bank with its £161m market capitalisation.

There are strong growth opportunities for small banks, but banking can be an expensive business that requires deep pockets. A small market position is a risk to banks like Metro as they have fewer customers to absorb their cost base. Metro’s shares have fallen 36% over the past year. The risk profile of small banks does not match my own risk tolerance, so I will not buy them.

In-store banks

Another way I could get exposure to UK banking in my portfolio is buying shares in a supermarket that also has a banking operation, such as Tesco or Sainsbury. With other sources of income often dwarfing their banking profits, I would face less direct risk here from swings in banking profitability than if I invested in a focused bank.

Then again, if I want to expose myself to banking, investing in supermarkets seems like a roundabout way to do it. I could reduce my risk in other ways, such as doing detailed research on banks to find the best ones for my own investment objectives.

Christopher Ruane owns shares in Lloyds Banking Group and Standard Chartered. The Motley Fool UK has recommended Barclays, HSBC Holdings, Lloyds Banking Group, Standard Chartered, and Tesco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.