Why I'd buy this bank over HSBC Holdings plc

HSBC, Paris

HSBC Holdings(LSE: HSBA) is one of the most popular banking stocks in the UK. That's understandable, as the bank looks relatively cheap from a valuation perspective, and offers a high dividend yield. Does that make HSBC a strong buy? I'm not so sure.

Frozen dividend

HSBC currently trades on a forward P/E ratio of a reasonable 13.5. Furthermore, after paying out 51 cents per share in dividends last year, the bank's yield is a high 5.3%. While those metrics might normally tempt me, there's a couple of factors that put me off buying shares in the £147bn market cap bank. 

The first is the frozen dividend. As a 'dividend growth' investor, I'm trying to build an income stream that increases year after year. Therefore, I look for companies that have increased their payouts in the past, and that are likely to increase them in the future.

My issue with HSBC is that the bank froze its dividend last year at and has stated: "In the current uncertain environment we plan to sustain the dividend at its current level for the foreseeable future." With City analysts predicting the same payment this year and next, and inflation running at around 3% per year, the purchasing power of HSBC's dividend is diminishing over time.

Furthermore, HSBC's dividend coverage is low. Last year it was just 0.14 times, and while it is predicted to improve dramatically this year to a ratio of 1.37, that's still a figure regarded as relatively risky. As a result, I won't be buying shares in the bank for now.

A better banking stock?

However, one peer stock that does offer considerable appeal right now, in my view, is OneSavings Bank(LSE: OSB). The challenger bank is a specialist lender and retail savings group that offers residential, buy-to-let and commercial mortgages, secured loans, development finance and savings solutions.

Profitability has soared in recent years, with net profit surging from £27m to £121m in the last three years alone. A trading update released this morning revealed further progress. It saw loan book growth of 17% for the nine months to 30 September, and stated that it expects net loan book growth of 20% for the full year. CEO Andy Golding commented: "OSB has yet again delivered exceptional performance in the third quarter of 2017 with strong loan book growth and record levels of organic originations at attractive margins."

The bank clearly has momentum at present, yet that's not reflected in the share price, in my opinion. With analysts expecting earnings of 48.3p per share this year, the stock trades on an insanely low forward P/E ratio of just 8.7.

Furthermore, the dividend prospects here look very appealing. After paying a maiden dividend of 3.9p in 2014, it has lifted its payout significantly over the last two years, paying out 8.7p and 10.5p per share. This year, analysts expect 20% growth to 12.6p, a yield of 3%, with coverage anticipated to be almost four times.

Shares in smaller companies such as OneSavings Bank can be more volatile than shares in blue-chip firms such as HSBC. However, for long-term investors, I believe the potential rewards on offer here outweigh the risks.

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Edward Sheldon has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings. 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.