Bank stocks can certainly be a great investment. Banks, in normal times, are reliable profit spinners. Left-wingers and related Occupiers may complain about banks' corrosive impact on society and economies, but investors usually take the view that if you can't beat them, join them. Buy the bank stocks and share in their windfall.
Indeed, many Hongkongers have built their pension portfolios around one stock: HSBC. The financial crisis put paid to that strategy, but banks remain a somewhat inevitable part of any portfolio. But it's hard to understand these complex entities, which make nothing tangible yet somehow create fantastic profits.
So, here is a primer. This discussion will centre on Hang Seng Bank, which is trading at 2.7 times its book value, much more than its peers (see table).
Although, as we'll see, it is not as pricey as that comparison makes it seem.
First, let's take a step back to understand how banks work. A bank makes money by borrowing mainly from depositors, and sometimes by issuing bonds through the capital markets. It then tries to make a spread above borrowing costs by making loans to customers and investments.
The profitability of its portfolio is typically measured by comparing the net interest income (the difference between interest income and borrowing costs) with the value of the assets, which is known as net interest margin.
