There was a general in the American Civil War – his name escapes me – and the last words he ever uttered were:

‘Nonsense! They couldn’t hit an elephant at this dist..’

I guess that shows the danger of complacency in the field of battle. The above story comes to mind whenever I hear someone say:

‘That share has fallen so much! It surely can’t fall any further..’

It sure can, is the answer. And these have often been the famous last words of stock market traders.

However with that warning ringing in my ears, it surely is tempting to think that the Irish bank shares have hit their lows – now that they are down about 70% from their all time highs of last year.

Is it time to go long? Or should ‘we follow the trend until it ends’ and go short?

There is a third option – Go long on the strongest looking stock in the sector, and go short on the weakest. This gives you a pretty good chance of making money whether the sector goes up or down. All you need is that the stock you are long in does relatively better than the stock you have shorted.

Welcome to my first blog, where I’ll be setting out my trading strategy on Irish banks and, far more importantly, the reasoning behind it. By the way feel free to move your mouse over the picture thing at the top right of this blog if you want to find out a bit more about me.

I have set out some facts and figures below, and from this my guess is that AIB has the strongest financial position, followed by Bank of Ireland. Next is Irish Life & Permanent, with Anglo Irish Bank being the one that looks to have the weakest financial position of the four.

So how am I going to trade that with my paddypowertrader spread trading account. The short answer is I’m going long on AIB and short on Anglo. It’s what’s known as a ‘pair trade’ and the result I’m looking for is that AIB does relatively better than Anglo – whether the sector goes up or down.

If the bank shares continue to fall but AIB falls less than Anglo I will make money. Or, if the sector rallies and AIB goes up more than Anglo, again I will make money. Of course if I’m wrong and AIB does worse than Anglo, I lose.

Also looking at the charts I don’t see a serious resistance level for AIB until E12. Anglo however looks to have marked resistance around and above E7.00.

The short position in Anglo should prevent me from losing my drawers if the sector continues to tank. The current difference between the share prices is E2.60 approx in AIB’s favour. My target is E5.00 difference, with a stop loss if the difference narrows to E1.00.

Some number crunching and other relevant facts are set out below.

Shares Look Cheap In Terms Of Fundamentals
The P/Es and dividend yields (here’s a reminder of P/Es and dividend yields), and the fact that the shares are trading at a discount to net asset value (nav) all seem to indicate that these shares are cheap. However, there is considerable uncertainty about earnings forecasts due to the property downturn. Investors are also fearful that the banks may have to reduce their high dividend payments. Discounts to nav would be reduced or eliminated by write offs.

P/Es:

AIB — 4.36 times

Anglo — 4.9

B of I — 4

IL&P — 3.1

Prospective dividend yields:

AIB — 9%

Anglo — 3.3%

B of I — 8%

IL&P — 8.7%

All figs as at 7Aug08.

A prospective dividend yield, by the way, is calculated in the same way as a regular dividend yield but it is based on what the dividend yield for this current year is expected to be rather than what it was last year. Investors pay more attention to dividend yields in bear markets, but the key issue is can we rely on the above forecast dividend yields? AIB announced an increase in dividend last week, so out of the four it looks the safest on this measure.

Share prices trading at a discount to net asset value (nav) as at 7th Aug ’08

AIB — 19%

Bof I — 8%

IL&P — 51%

Anglo at a share price of E6.40 is trading at a premium to nav of 18%

Dependence On Property Lending

Residential mortgages:

AIB — 24% of total loan book

B of I — 47%

IL&P — 89%

Anglo — (majority of mortgages are commercial rather than residential)

Total property & construction loans:

AIB — 55%

B of I — 71%

IL&P — 89%

Anglo — (no figs to hand but considered to have higher exposure than AIB & B of I)

So you can see from the above that dependence on property and construction lending is pretty high for all of the Irish banks, but IL&P and Anglo are even more exposed than AIB and B of I.

Tier 1 Capital Ratios
If you read the Financial Times there’s a good chance you’ll have come across Tier 1s, Tier 2s and even Tier 3s before.

A Tier 1 ratio is the core measure of a bank’s strength from a regulator’s point of view. It is the total amount of equity capital and reserves, expressed as a percentage of the loans advances. Equity capital for this purpose includes instruments that can not be redeemed at the option of the holder. Tier 2 and the others are variants on the theme.

A Tier 1 ratio of 4% is considered adequate, and 6% is considered to be well capitalised.

AIB — 7.5% (per interim results announced July’08)

Anglo — 5.8% (per estimates by Merrion stockbrokers)

B/I — 8.1% (per Morningstar estimates)

However it should be noted that what sank Northern Rock was not a lack of capital but a lack of liquidity i.e. it was more dependent on the wholesale market (i.e. borrowing from other banks) for funds than it’s peers. It simply ran out of cash when it could not borrow the amount it required on this market.

The Irish Financial Regulator raised the liquidity requirements for the banks following the Northern Rock collapse, so this should reduce the risk of a liquidity crisis for an Irish bank.

Short Selling
Short sellers in this context are mostly hedge funds. They sell the borrowed stock and subsequently aim to buy it back at a lower price. The vast majority of stock out on loan is lent to short sellers who are betting on a share price fall.

Per Euroclear the stock out on loan in July ’08 was as follows:

AIB — 4%

Anglo — 14%

B of I — 9%

IL&P — 11%

The above figures indicate the short sellers are targeting Anglo in particular, with AIB attracting the least attention.

There are two schools of thought about a high level of short interest in a stock, one bullish and one bearish.

The bullish angle is that this shorted stock must be bought back at some stage, and could therefore lead to a sharp rally. However the shorting could continue for a while , thereby leading to a further decline, before this happens.

The bearish angle is that short sellers are usually more sophisticated and better informed than the average investor, therefore one should pay attention to what they are doing (this certainly proved to be the case for Northern Rock shares which had the living daylights shorted out of them by hedge funds.)

Personally I find the bearish argument more convincing. Of course the short sellers are not always right. They had shorted a massive 27% of Alliance & Leicester stock when along came Banco Santander with a takeover bid and the price nearly doubled!

The Credit Crunch
Losses incurred by US banks in the sub prime sector drained the interbank market of cash, (which basically means that banks weren’t sure who was most likely to go bust so they got a lot more cautious about lending to each other). The result was a dramatic rise in the cost of funds on this market and on the wholesale market generally. This coincided with a property downturn in most Western economies which exposed banks to further losses.

The bulls say that the worst is over, the bears say the situation will deteriorate further. Pay your money and take your pick …

Technical Analysis

There is some comfort for the bulls from the current charts. The Irish bank shares recently touched the low points they hit in January 2000, which is the 10 year low. Buyers came in large numbers shortly after Jan 2000 resulting in a major rally, and the bulls hope that this will also prove to be the turning point in ’08.

However if we break below these levels then a further fall is in prospect.

Possibility Of A Takeover
Banco Santander’s recent takeover bid for Alliance & Leicester has raised the possibility of a takeover bid for an Irish bank. However the chances of this currently look remote.

Takeovers are usually more frequent in bull markets, when the buying bank offers its highly rated shares in the bid for a lower rated bank e.g. a bank trading on a P/E of 15 makes a bid for a bank trading on a P/E of 10, offering a share for share exchange. In this way the takeover is earnings enhancing for the bidder.

With most banks trading on P/Es in the low single figures, and concern about capital ratios, takeover activity looks unlikely.

So I don’t expect any takeover activity to disrupt my bet that AIB will outperform Anglo in the short term.