A challenger bank that could beat HSBC Holdings plc in 2018

A friend of mine has held HSBC Holdings(LSE: HSBA) shares for several decades -- he started out inheriting some Midland Bank shares, which were later converted.

Throughout the banking crisis he'd say things to me like "I don't understand what it's all about, but the slimy bankers will come out smelling like roses as they always do," and he went on taking his annual dividend as scrip.

That buy and forget approach has served him well, with HSBC shares up around 1,500% in the time he's held them. And reinvesting those dividends, which in recent years have been averaging around 5%, has made a huge difference.

Forecasts suggest yields of around 5% for the next couple of years, and that's after the bank has almost finished returning a cool $2bn to investors in the form of share buybacks.

Attractive valuation

At a share price of 790p, we're looking at P/E multiples of around 14, which is close to the long-term FTSE 100 average.

For me HSBC's valuation is about as good as they come. It's not stupidly cheap, or overheated in the hope of growth, with the risks those entail. It's just a very good company at a good price -- the kind of thing that Warren Buffett exhorts us to seek.

Liquidity looks fine now too, after HSBC's third-quarter update revealed a strong CET1 ratio of 14.6% at 30 September. And under the worst of the Bank of England's stress tests, reported in November, that would have dropped to a still comfortable 8.9%.

In short, HSBC is a cash cow.

An even better one?

But over the medium term, I think the so-called challenger banks could do even better, partly because sentiment seems weaker towards smaller financial companies right now.

One of those is Secure Trust Bank(LSE: STB), whose shares do seem to be out of favour at the moment -- they're down 47% since their peak in November 2015, to 1,798p.

Thursday's full-year trading update was essentially "in line with market expectations," which suggests a flat year for earnings for 2017. But what excites me about the outlook for Secure Trust is forecasts for EPS growth of 27% this year followed by 33% in 2019.

And the latest update gives me confidence that the bank's risk is falling. Secure Trust has "continued to reposition its lending portfolios away from higher-risk consumer lending during the final quarter of 2017," and has sold what was left of its unsecured personal loan book.

Earnings growth

If forecasts come good, the company's P/E would drop to under eight by 2019, with PEG ratios for this year and next of 0.4 and 0.2 respectively. A PEG of less than 0.7 is often seen as very attractive by growth investors, and Secure Trust's relatively small portion of the very large banking market is what makes such potential growth possible.

Dividends are strong and progressive, with a yield of 4.4% expected for the year just ended, and predicted to grow to 5.2% by 2019. And that dividend would be significantly better covered by earnings than HSBC's, with cover of 2.4 times compared to HSBC's 1.4.

The dividend is progressive too, and I see significant scope for uplifts in the coming years -- buying now could lock in some strongly-rising effective future yields.

And as Secure Trust is 100% UK-focused, I really don't see much in the way of the Brexit risk that's holding the banking sector back.

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Alan Oscroft has no position in any of the 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.

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