Money: Beginner's guide to investing in shares: Banks may lose their shine

The sector is riding high on takeover fever, but for how long, asks Magnus Grimond

LAST year's unseemly rush by the Halifax and five other big mutually owned financial groups to the stock market did more in one year for private share ownership than state privatisations managed in 13. If you are a small investor, you are more likely to own a bit of a building society- turned-bank such as the Halifax than any other company on the stock market. Figures from ProShare, the lobby group, show that the conversion of the former mutuals, which included Alliance & Leicester, Woolwich and Bristol & West building societies, has turned 7.5 million or more savers or policyholders into shareholders as well.

If you are one of these, you have probably been bewildered by the varying fortunes of the newly floated societies. Shares in the Halifax and Woolwich have meandered only a little from their launch price, but those ofNorthern Rock and Alliance & Leicester have soared by as much as 50 per cent.

Much of this starkly differing performance is down to takeover fever sweeping the bank sector. The restraint of Halifax shares has been partly due to the feeling that the mortgage giant is too large to be swallowed, while Woolwich is expected to use its statutory five-year protection from takeover bids to fend off unwelcome offers. By contrast, Northern Rock and Alliance & Leicester, each for different reasons, are seen as takeover targets.

But it is very unwise for long-term investors to hold shares solely on the hope that a bidder will pay an outrageous price for them. These shares have already come a long way: those of the Woolwich started their market life at double the level of official estimates just 18 months before, while, as forecasts from City stockbrokers Merrill Lynch show, Northern Rock's now stand on a heady price-earnings (p/e) ratio of 21, a least a fifth higher than the stock market as a whole.

The current glamour of banks reflects a fashionability to which the sector is not accustomed. Ten years ago, bank shares languished on p/e multiples of half those of the rest of the market, while their dividends yielded income as much as 50 per cent above the average. But in the last six years, banks have outperformed other shares by around 150 per cent.

This is mainly due to two real, or "fundamental", changes to the way banks operate. First, many people believe that for the first time in a generation the British economy is being better managed, with a determination to keep inflation low and avoid the boom-and-bust cycle. These economic cycles have always caught out the banks, which have notproved very good at their main business of lending money. The assumption now is that, if businesses and individuals making up the economy operate on a more even keel, bank loans to them should be of better quality than in the past.

The second factor boosting the sector is better management of the banks themselves. The discredited old guard that ran the industry in the 1980s has largely been replaced. Management has been weeding out loss-making lines, even at the expense of a few sacred cows. Barclays and NatWest have dumped much of their expensively created but poorly performing investment banking. Another "core" business scaled back in the face of wafer-thin margins is lending to big companies, which can often borrow from the money markets more cheaply. Costs have been cut relentlessly and surplus funds given back to shareholders as higher dividends or share buy-backs, not pumped into the economy as loans to flaky borrowers.

The arrival last year of the building societies and the general urge to merge have come on top of all this. The former mutuals have had a dramatic effect on the market indices. Over the past year, the weighting of banks in the main FT-SE 100 index has grown by a third: they now represent a fifth of the measure. The fund managers who slavishly follow the index have had to scramble for shares in the former building societies or older banks to maintain their weighting, pushing up share prices.

Can this last? Many analysts are bubbling with enthusiasm on takeover hopes, but these may be overdone. Politics is likely to scupper the much- rumoured merger of Barclays and NatWest, given the huge share of the English market the combined bank would control. Straight takeovers would require heroic assumptions about the UK market's prospects to justify paying current stock market prices.

But predicting takeovers is only for the brave. Bank shares are now generally on a p/e rating at or above the market for the first time in years, while bad debts have fallen to historically low levels. That leaves little room for mistakes if economic conditions become more turbulent. HSBC and Standard Chartered, with big operations in the Far East, have already seen their previous heady ratings cut down to size. With the UK economy set for a downturn in 1998, the sector may prove duller than some wilder spirits imagine.