Why this top fund manager believes Barclays plc and RBS are seriously undervalued

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Barclays signage

Nick Kirrage is the co-manager of the hugely successful Schroders Global Recovery Fund. The fund is only a year old, but last year produced a return of 31% for investors -- outpacing its benchmark and its peers. 

Kirrage is a traditional contrarian value investor. Last year's performance was a reflection of his decision to go all-in on miners 18 months ago, despite market sentiment towards the sector. His call on companies such as Anglo American -- a five-bagger in 18 months -- have helped the Global Recovery Fund shoot to the top of the UK's fund performance tables. 

Now Kirrage is targeting a different sector as he tries to reproduce last year's returns for investors. Ever the contrarian, Kirrage has turned his attention to banks, a sector he believes is deeply undervalued. 

Seeking value in dark corners 

The two banking stocks the manager likes best are Royal Bank of Scotland(LSE: RBS) and Barclays(LSE: BARC). There's no denying that this isn't the first time a star fund manager has recommended these stocks. 

Bombed-out banks have attracted the attention of contrarians on many occasions since the crisis but as these firms continue to restructure, there's been no reward for adventurous managers. 

So why does Kirrage believe it's now the time for these banks to shine? Well, for a start banks are cheap. After years of restructuring and tens of billions in fines, investors are clearly still afraid of the sector. The good news is that the lack of investor attention has sent bank valuations plunging, so if you're looking for cheap stocks, the banking sector is where you will find them. 

And considering the tectonic shift that the banking sector has undergone since the crisis, Kirrage believes these depressed valuations are unwarranted. 

Take RBS for example. Since the crisis the bank has been continually de-risking, selling off non-core assets, cutting costs and bolstering its balance sheet. As a result, today the bank is arguably in a stronger position than it has ever been before, but due to continuing legal issues, the shares are around 50% below where they were at the end of 2009. 

The same can be said for Barclays. Shares in the bank are still more than a third off year-end 2009 levels, but today the bank has a much stronger balance sheet and hugely profitable core business. 

During 2016 Barclays' core business produced a 4% growth in profit before tax to £6.4bn and a return on average allocated tangible equity -- a measure of bank profitability -- of 19.3% at the UK and 8% at the international level. Including nasties, return on tangible equity was 3.6%. 

The issue of timing 

The big problem here is timing. Even though these banks may look cheap now, they've looked cheap in one way or another since 2009, as so far there's been no recovery. Still, for the first time in nearly a decade, it now looks as if the environment is improving for banks.

Inflation is picking up, and interest rates are ticking higher, both of which should help improve profitability. As both RBS and Barclays trade at a price-to-tangible book ratio of around 0.8, there could be considerable upside on offer if the sector really is on the verge of a comeback. 

Make money not mistakes 

Nick Kirrage may believe in RBS and Barclays, but that doesn't mean you should as well. Before investing in any business, you should always conduct your own due diligence, failing to do so can cost you thousands.

To help you avoid this crucial mistake, and many others, the Motley Fool has put together this new free report entitled The Worst Mistakes Investors Make.

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Barclays. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.