Since the end of the Financial Crisis the story for the UK's largest banks has always been that a turnaround is just around the corner. Well, we're going on eight years now since the bottom fell out of the world economy and the likes of Provident Financial (LSE: PFG) and Virgin Money (LSE: VM) are still handily outperforming the big domestic lenders. Is this trend going to continue?
Investors in subprime lender Provident Financial will certainly be hoping that the shares can replicate their stunning 180% increase posted over the past five years. The bad news is that lending is always a cyclical business dependent on the health of the overall economy and extending credit cards, auto financing and personal loans to customers with poor credit histories is even more risky.
The upshot is that Provident has a long history of dealing with the vagaries of its business. And when the times are good, as they are now, Provident can pump out significant profits. In 2015 Provident's return on equity was 46%, far, far ahead of the profitability of major mainstream lenders, and adjusted pre-tax profits jumped 25% to hit £292m.
Management isn't shy about returning these mega profits to shareholders and dividends now yield a whopping 4.13%, which is again far ahead of what many large banks are offering. Half-year results covering July through mid-October also showed solid mid-single-digit growth in customer numbers in each of Provident's main divisions, lessening worries over the impact of Brexit.
While Provident would suffer just as much, if not more, than larger mainstream lenders during an economic downturn, its long history of navigating tough economic environments, high profitability and healthy balance sheet make it a more attractive long-term option in my eyes.
Like a Virgin
Investors who like Provident's lean business model and high profitability but prefer a more staid retail option would do well to consider Virgin Money. Shares of the challenger bank are up 17% since the company's November 2014 IPO due its relatively low cost operations, growing profitability and high potential to steal market share from larger competitors.
The secret to Virgin's success has been cutting the fat from the former Northern Rock assets it purchased from the government in 2011. Year-on-year results from H1 2016 show just how effective Virgin management has been: the bank's cost-to-income ratio fell from 68.3% to 58.8%, allowing return on tangible equity to increase from 9.5% to 12.2% and pre-tax profits to jump 53% to £101m.
Virgin is targeting a 50% cost-to-income ratio in 2017, which is eminently possible as the bank wrings further efficiencies out of legacy Northern Rock assets and benefits from economies of scale as the business grows. Growth has been no problem for Virgin as first-half results saw a 19% year-on-year rise in gross mortgage lending and 31% rise in credit card balances over the same period.
If Virgin can continue to take market share from bigger lenders while simultaneously improving internal operations then analysts' forecast for a 33% rise in 2016 earnings looks very achievable. With no legacy regulatory issues, lower costs and higher growth prospects than the major retail banks, I'd bet on Virgin continuing to outperform larger competitors for the foreseeable future.
Of course, banking remains a cyclical industry, something even quality companies such as Provident and Virgin can't escape. That's why the Motley Fool's top growth share is a non-cyclical retailer that has increased sales every single year since going public in 1997.
The market hasn't ignored this stunning performance and shares have increased more than 240% in value over the past five years. Best of all, with international expansion just beginning the Motley Fool's Head of Investing believes the company could triple again in the coming decade.
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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.