Why Ed Balls Is Wrong About Royal Bank Of Scotland Group plc

If he gets the chance, Ed Balls should sell Royal Bank of Scotland (LSE: RBS) (NYSE: RBS.US) shares fast, rather than hold on to them.

A laudable goal

In recent news, Shadow Chancellor of the Exchequer Ed Balls reckons a British government run by the Labour Party would hold off selling its majority ownership in Royal Bank of Scotland so that taxpayers get their money back.

I can’t argue with the warm sentiment behind such a declaration. After all, every investor wants to get more back from an investment than he or she puts in. Even if an investment underperforms our expectations, we at least want to get our money back.

However, apparently missing from Mr Balls’s assessment is any calculation on the risk the government will be taking by holding the shares. The longer the hold, the more the odds of an unsuccessful outcome begin to stack up, in my view. “I’m not selling until they go back up,” is scant justification for a ‘hold’ in the cutthroat world of investing.

Working on the assumption that Royal Bank of Scotland shares will go up from here looks like something of a shaky proposition. They may, but there are also many reasons to suppose that they may go down, too.

Still in the hole

The government bunged £45 billion of taxpayer’s money at Royal Bank of Scotland Group in 2008, as the financial crisis thumped into the UK’s financial and economic system and banks found themselves air running like Wile E. Coyote, as the land gave way to the canyon.

Our government still finds itself saddled with around 80% of what was, at the time, a financial house of cards. RBS’s plans didn’t work out and that led to the nation’s bailout money seeing the government take ownership of the bank at about 502p per share, after the firm posted the biggest annual corporate loss in Britain’s entire history.

Today’s 360p or so shows how far there is still to travel if the government wants to get its money back. The situation seems even more dire when we consider that the shares floated around this level since early 2013 — more than two years. So why aren’t the shares making progress?

A double drag

UK-focused banks, such as RBS, face an ongoing double drag on share-price progress, which renders them unattractive as an investment proposition, or even as a ‘hold’.

There’s some evidence that regulators’ rhetoric is ratcheting up. Just this week news reports came through citing a senior Bank of England official saying that it will take another five years or more to make real inroads into the dominance of Britain’s five biggest banks. So, not only will regulators keep the banks in check, they will hack them down in size as well. That’s a powerful current dragging against a longer-term investment in RBS.

The other big problem for RBS and its peer banks is their close attachment to general macro-economic cycles. Banks are cyclical to the very core, and that’s what makes them dodgy buy-and-forget investments. Share prices in the sector rise and fall with profits, and cash flow in line with the undulations of the macro-economic cycle.

That’s why the stock market marks down the value of banks as we progress through the up-curve of the economic cycle — right now, in other words. There’s often gradual P/E compression in anticipation of the next peak-earnings event as the cycle unfolds. I think the valuation-compression effect we see with cyclical firms such RBS is the second drag against total investor returns for holders like the British Government.

End game

The longer we hold bank shares now, the closer we get to the end game. It won’t be pretty. The final big share price movement will likely begin with peak profits and end with share-price collapse near by. After that, it’s rinse and repeat. If he insists on waiting to get his money back, Ed Balls could be waiting a very long time…