Lloyds (LSE:LLOY) shares have underperformed in recent months. That’s partially due to the shock of the Silicon Valley Bank (SVB) fiasco and the narrative that it’s only going to get worse for banks from here — a reference to the notion that interest rates will inevitably start falling.
But I don’t see it that way. I’d argue that current macroeconomic environment creates as many headwinds for banks as it does tailwinds.
However, the prevailing narrative is clearly pushing the price down. And that’s fine with me, because — channelling my inner Warren Buffett — this gives me a chance to buy more of the stocks I like at lower prices.
Interest rates
Much discourse about the prospects of banks concerns interest rates. Clearly at this moment, higher interest rates mean banks are receiving higher net interest incomes. This is particularly important for Lloyds as its more interest rate sensitive than other institutions. That’s partially because it’s doesn’t have an investment arm.
Equally, this is also a challenging period for banks. That’s because customers suffer when interest rates go up. When people and businesses alike default on their mortgages or loans, banks have to put aside more money for bad debt.
In Q1, Lloyds increased bad loan provisions to £243m provision — that was lower than I anticipated. But with interest rates continuing to go up, I’m not too optimistic about the coming quarters.
It’s also the case that higher interest rates slow loan book growth. After all, many of us will decide not to take a mortgage on a new house when interest rates are at their highest for three decades.
Instead, I’m buying Lloyds now — with the shares around 44p — for the medium term. During which I’m hoping to see interest rates moderate to around 2-3%, allowing for elevated interest income, but lowering bad debt concerns.
Forward dividend
Lloyds paid out 2.4p per share in 2022, and analysts expect this to rise to 2.7p and 3p in 2023 and 2024 respectively. Currently, the dividend yield sits at a healthy 5.4% — that’s far above the 3.8% average for UK blue-chip shares.
But moving forward to 2024, the dividend yield extends to 7% at the current share price.
These inflated dividend payments would likely be easily affordable. The dividend coverage ratio in 2021 was 3.75 and 3.04 in 2022. That means earnings could cover stated dividends 3.75 and 3.04 times. Normally, a yield above two is considered healthy.
It’s worth highlighting that some analysts see the dividend moving even higher, reaching 3.1p in 2024.
Undervalued
Dividends are by no means guaranteed, but I’m comforted by the strong coverage ratio. And share price growth is even less certain. But with a price-to-earnings of just 6.1 and discounted cash flow calculation suggesting the bank is undervalued by as much as 50%, I’m pretty bullish.
For me, this is a buying opportunity and that’s exactly what I’m doing.
