The UK's challenger banks have so far failed to strike a chord with investors due to general concerns about the banking sector, and caution regarding economic growth.
However, I believe that the majority of these concerns are unwarranted. Challenger banks such as OneSavings(LSE: OSB) have carved out a unique niche for themselves, and the market's hostile attitude towards the sector has pushed valuations down to highly attractive levels.
This morning, Arbuthnot Banking Group(LSE: ARBB) reported that for the three months to September, overall loan volumes have risen by 75% over the year-ago period -- the kind of growth that the UK's big four high street banks would kill for.
The financial services company also reported 33% loan book growth for its private bank subsidiary, Arbuthnot Latham. Moreover, the group's commercial bank division is now planning to launch an infrastructure fund to capitalise on demand from investors for such assets.
And as the top line is growing, the group's costs are also falling. According to today's trading update, the overall cost of funds for Arbuthnot Latham has fallen by 30% from the prior year to a blended rate of 0.49%, due to the Bank of England's term funding scheme.
Overall, this is an excellent update from the company. Higher demand for loans coupled with a lower cost of funding means wider margins, and I believe that this growth should help turn the group into one of the market's dividend champions.
According to current City forecasts, Arbuthnot is on track to earn 49p per share this year, and 82p per share for 2018. Analysts have pencilled in a dividend payout of 33p per share for 2018, but considering the firm has historically paid out 70% of earnings to investors via dividends, I believe a dividend of 55p to 60p is more likely. As the financial business continues to notch up revenue growth, the dividend could hit 70p or 80p by 2019, up 100% from current levels.
At the time of writing, shares in Arbuthnot trade at a 2018 P/E of 15.2.
OneSavings is probably the most unloved challenger. Even though the bank is on track to grow earnings per share by 15% for 2017, the shares only trade at a forward P/E of 8, falling to 7.4 for 2019. What's more, the shares support a dividend yield of 3.5% with the payout covered 3.5 times by earnings per share.
The banking sector trades at an average forward P/E of 10.2 so, if OneSavings' shares move back to the average sector valuation, investors could be looking at an upside of 38% from current levels.
There's also plenty of scope for the company to increase its dividend payout.
With a reported Equity Tier 1 capital ratio of more than 13%, the bank has a strong balance sheet and can afford to ramp up cash payouts to investors. According to my figures, a doubling of the payout to 27.2p would still leave the distribution covered twice by projected earnings per share, and the stock would support a dividend yield of 7.2%.
Looking for other opportunities
Arbuthnot and OneSavings both have bright outlooks, although as I mentioned at the beginning of this article, banking stocks are not for everyone.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.