Here’s the long and the short of my little story today: stock selection has been tough in 2014, and there’s no convincing sign it’ll be any easier in 2015. The banks remain attractive investment options but they too have their own risks. Is Lloyds Banking Group (LSE: LLOY) (NYSE: LYG.US) though about to become an obvious choice for earnings-hungry investors?
Well, like several of the other major banks, it has shown some signs of improvement over the past few months. Lloyds, though, is as we are all too painfully aware partly government owned (25%), so its performance history can’t be directly related to its performance outlook. Investors are now keen to know what will likely happen when that ‘parental support’ is taken away again, and whether the bank can ultimately survive on its own.
Let’s take a look at whether the government’s likely to bail out of the bank soon and whether Lloyds is worth holding onto.
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Is Lloyds a solid investment?
The bank looks good at the moment. It recently reported a 35% rise in its underlying third quarter profit to £5.97 billion. Its net interest margin rose to 2.44% as expected, and impairment charges fell nearly 60%. There’s still no dividend to speak of so other financial metrics that I’d normally discuss here become a little obsolete. It’s worth noting though that current price targets in the City go as high as 115p.
A small part of the bank’s recent lift can also be attributed to its new digital strategy. I’m no tech guru but as the bank becomes more digitally progressive, I suspect it’ll lose more and more staff and become more efficient. I don’t think it’ll be as pleasant dealing with the bank over the phone, but that’s just me.
Risks
Lloyds’ bottom line looks set to improve next year, but the risks it faces are very real. The bank funds around a third of all British lending. If rates stay low next year, policy makers will run the risk of creating a housing bubble (a bubble that will ultimately burst). If rates rise, there’s the chance tightened policy will snuff out the economic recovery (which would hurt all the banks).
How it could play out
Lloyds’ valuation has improved over the past couple of months because its earnings outlook has become brighter. It’s now at a level that has in the past triggered a divestment by the government. If the government (via UK Financial Investments) sells a further stake, the bank’s share price will likely fall — as has also happened in the past. However, it will likely recover, assuming the bank can maintain its net interest margin, grow its balance sheet, and keep its costs down.
Further upside?
The government originally rescued Lloyds Banking Group because it was determined that the British economy shouldn’t have to withstand a banking collapse of that size. It’s a moral hazard that policy makers are still willing to accept. The bank has since stabilised and is looking for ways to grow its profit margin (as opposed to its size). While a lack of government support in the short term could be negative for the company, ultimately it will provide the board with more scope to compete for the best human resources through higher salaries and bonuses. That’s ultimately a positive for investors.
In addition, it may have only scraped through the ECB’s stress tests, but that does at least pave the way for some form of dividend payment next year — however small.
There is significant upside potential for Lloyds in 2015, but there are also risks and challenges that the lender will need to come to terms with and resolve. Welcome to the stock market: no pain, no gain; no risk, no reward.
