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Stock Strategist

Royal Bank of Scotland Is a Diamond in the Rough

The bank is turning the corner, and we don't think investors appreciate its potential.

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 Royal Bank of Scotland (RBS)/(RBS) has been undervalued by investors because of the depth and complexity of its problems, but we think it will increasingly be in a position to demonstrate its underlying strength. We think investors should be paying attention to RBS' legal liabilities, which we think will be large but manageable; the attractive profitability of RBS' retail business, which has been obscured by large nonoperating costs; and the excess capital that RBS' transformation is likely to generate by 2018, which we estimate at GBP 20 billion, enough to repurchase three fourths of the government's 72% stake at current prices.

While many investors are familiar with the broad strokes of this story, RBS' recovery from the financial crisis has been obscured by headlines dominated by losses and regulatory settlements. Few investors, therefore, appreciate the significance of its transformation or the strength of its remaining businesses. While we anticipate that statutory losses are likely to continue through 2016, we believe the shares will rise ahead of reported profitability improvements. Specifically, we think the shares are likely to rerate materially over the next 6-18 months as major points of uncertainty, like the size of legal settlements related to the underwriting of U.S. mortgage-backed securities and the restructuring of the investment bank, are resolved.

Erin Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.