Why Lloyds Banking Group plc Is A Better Buy Than HSBC Holdings plc & Virgin Money Holdings (UK) PLC

Lloyds Banking Group plc (LON:LLOY), HSBC Holdings plc (LON:HSBA) & Virgin Money Holdings (UK) PLC (LON:VM): A look at differences in strategy, credit quality, financial metrics and valuations.

| More on:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Here at The Motley Fool, many authors (including myself) are huge fans of Lloyds Banking Group (LSE: LLOY). I would like to think that we like it for good reasons, too. Profitability at Lloyds is returning to healthy levels, its balance sheet has been strengthened and the bank looks set to return to regular dividend payments.

However, critics point out that Lloyds’ shares trade at a premium to many of its peers and hefty PPI provisions continues to drag on earnings. In addition, the bank is highly exposed to the UK property market and is vulnerable to a rate hike by the Bank of England. Nevertheless, I still think the outlook for Lloyds remains positive, and it is a better buy than HSBC (LSE: HSBA) and Virgin Money Holdings (LSE: VM).

Domestic Scale vs Global Diversification

Domestic focus and global diversification are generally considered two distinct banking business model. Banks adopting the domestic focus model rely on building scale in one key market, in order to benefit from local economies of scale. This is of particular benefit in retail banking and Lloyds and Virgin Money are very much in this category.

On the other hand, HSBC is adopting the global diversification model. This strategy focuses on reducing earnings volatility by spreading risks across the world and taking advantage of global economies of scale. Global economies of scale are usually most beneficial for investment banking and wealth management markets.

Although both business models have their own advantages and disadvantages, domestic focus is generally the preferred model by many analysts today. Ever since the recession, banks with local scale have typically been more profitable, which explains why the shares of most domestically focussed banks trade at a premium to their diversified peers.

ROE and Valuations

When comparing between different banks, the most commonly used financial metric is the return on equity (ROE). This is because, bank that have higher ROEs (i.e. the more profitable ones) typically deserve to trade at more pricey valuation multiples.

 

Return on equity

(2015 estimate)

Price-to-book

Forward P/E

(2015 forecast)

Lloyds 15.3% 1.32 8.6
HSBC 8.2% 0.81 9.9
Virgin Money 8.0% 1.22 15.2

Here, we see why Lloyds trades at a higher price-to-book value than its two competitors. The greater profitability of Lloyds, as reflected by its return on equity, means it can generate more profit for every £1 in equity the bank holds. And, it is also important to note that although the bank trades at a premium on a price-to-book basis, it is actually cheaper than its two competitors on a forward price-to-earnings basis.

Another interesting point is that although Virgin Money is one of the larger challenger banks, it is not very profitable. This is partly due to the fact that it is holding excess capital, which it has yet to deploy efficiently. But this can be viewed as a positive, as it means the bank can afford to grow its loan book more quickly and pay greater returns to shareholders.

Near-Term Catalysts

Critics are concerned that provisions for legacy misconduct issues, most notably, PPI provisions, remain stubbornly high. And, this could continue to hurt the bank’s “actual” profitability and restrict the amount of capital available to make dividend payments. However, I see potential positive catalysts that should reduce the level of provisions going forward. PPI claims are already beginning to decline and the FCA, the UK financial regulator, has proposed to set a deadline for further claims by 2018.

Another positive for Lloyds (and Virgin Money) is the robustness of the UK economy and the property market. Although exposure to just one market is risky, the timing for being exposed to the UK market couldn’t get any better. Growth in much of Europe and Japan is sluggish, whilst emerging markets are slowing down fast. This will likely act as a drag on earnings growth for HSBC, as loan losses are projected to rise, whilst the bank would struggle to find new lending in a downturn.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Mature couple at the beach
Investing Articles

6 stocks that Fools have been buying!

Our Foolish freelancers are putting their money where their mouths are and buying these stocks in recent weeks.

Read more »

Black woman using loudspeaker to be heard
Investing Articles

I was right about the Barclays share price! Here’s what I think happens next

Jon Smith explains why he still feels the Barclays share price is undervalued and flags up why updates on its…

Read more »

Investing Articles

Where I’d start investing £8,000 in April 2024

Writer Ben McPoland highlights two areas of the stock market that he would target if he were to start investing…

Read more »

View of Tower Bridge in Autumn
Investing Articles

Ahead of the ISA deadline, here are 3 FTSE 100 stocks I’d consider

Jon Smith notes down some FTSE 100 stocks in sectors ranging from property to retail that he thinks could offer…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

Why I think Rolls-Royce shares will pay a dividend in 2024

Stephen Wright thinks Rolls-Royce shares are about to pay a dividend again. But he isn’t convinced this is something investors…

Read more »

Investing Articles

1 of the best UK shares to consider buying in April

Higher gold prices and a falling share price have put this FTSE 250 stock on Stephen Wright's list of UK…

Read more »

Person holding magnifying glass over important document, reading the small print
Investing Articles

The market is wrong about this FTSE 250 stock. I’m buying it in April

Stephen Wright thinks investors should look past a 49% decline in earnings per share and consider investing in a FTSE…

Read more »

Black father and two young daughters dancing at home
Investing Articles

1 FTSE 250 stock I own, and 1 I’d love to buy

Our writer explains why she’s eyeing up this FTSE 250 growth phenomenon, and may buy more shares in this property…

Read more »