Peel Hunt sees attractions of the 'challenger banks'

After some weeks of significant share price weakness in the trio, Peel Hunt said there was now an opportunity to acquire "high-quality/high-return" specialist lending businesses at what are "compelling valuations".

From its position that comfort around credit quality is the "core principal" governing investing in this sub-sector, the broker has found each of the three companies has a conservative level of provisioning, with little of the legacy issues affecting many other lenders.

Even taking a relatively conservative stance in forecasts around the normalisation of the cost of risk has shown the stocks will still deliver attractive returns, with concerns about exposure to buy-to-let lending overstated.

The business model of these challenger banks is attractive, with each having a relatively small share of a larger market, with the potential for loan growth to exceed 15% "given the ongoing SME credit gap between supply and demand and the support by government to narrow the gap", plus a heartening focus on client relationships that provides a better understanding of clients' specific credit risk.

"There is also scope for significant operational leverage, given the efficiency of the operating models, in particular the lack of legacy infrastructure."

On valuation, Peel Hunt's forecasts assume an average return on equity of 21% in 2016, yet the stocks trade on an average P/NAV of 1.6 times.

"Although we conservatively forecast some deterioration in the level of returns in coming years, in our view the current share prices are overly pessimistic with regards to the future earnings trajectory," it said, with compound earnings forecast to grow 13% over the next three years.

Shawbrook is the top pick, given a 350p target price, with OneSavings set a price target of 360 and Aldermore 225p.