As a shareholder myself, I’m always happy to extol the virtues of Lloyds Banking Group (LSE: LLOY) to anyone who’ll listen. What I like best about Lloyds is the strength of its recovery from the deep dark days of the crash.

Lloyds has come out of it a lot faster than fellow bailed-out rival Royal Bank of Scotland, being a good two years ahead in the dividend stakes — Lloyd’s first PRA-approved payment came in 2014, and by last year Lloyds paid a yield of 3.1%, while RBS might manage a 0.2% yield in 2016 if we’re lucky. On top of that, Lloyds is on a forward P/E of under nine for this year and next, with its dividends predicted to yield 6.5% and 7.7% for the two years respectively.

The poor sentiment towards Lloyds I can only put down to a few things. Firstly, Lloyds was the naughtiest bank in the PPI mis-selling scandal, and added £4bn to its provision in 2015, taking the total to £16bn — but it really looks like a line will finally be drawn under that in a couple of years’ time. The overhang of government-owned slice must also be weighing on the shares, and we surely won’t get a true free-market price until they’re all back in private hands. And then, of course, there’s the general malaise afflicting the whole banking sector.


But while Lloyds shares have lost 10%, to 68p, since November 2014, Virgin Money (LSE: VM), which floated that month, has seen its shares gain 25% to 356p. A big part of the attraction of Virgin, and the other challenger banks, is that they don’t have the baggage and the murky pasts of their bigger rivals. Virgin was formed from a buyout of what was left of Northern Rock, and in the years since acquiring its good assets, Virgin has streamlined the business and returned it to profit.

From a maiden £34m pre-tax profit as a quoted company in 2014, Virgin Money is expected to have grown that to £155m in 2015, with forecasts taking it all the way to £264m by 2017. That would see earnings per share gain 40% this year and another 30% next, taking Virgin’s P/E down to 8.5 by 2017 — even lower than Lloyds’. Dividends aren’t there yet, but forecasts suggest a yield of 2.6% by 2017. That would be nearly four times covered by earnings, so there should be some great potential for future dividend growth.

We don’t often see a bank with a meaningful PEG ratio (which compares the P/E with expected EPS growth), but in the case of Virgin we have two years of ratios at just 0.3 (where 0.7 or lower is usually seen as a good growth sign).

Growth potential

With the challenger banks being such small fish in a very large pond, they only need to take a tiny proportion of the overall market to boost their own income significantly. So, with only a few percent of the UK’s mortgage and credit card markets right now, Virgin Money has plenty of scope for its growth to continue for quite some time. By contrast, Lloyds’ 20% share of the mortgage market makes significant expansion that much harder.

Expansion will need considerable capital expenditure, but Virgin has the freedom of an essentially blank slate. It can spread its wings precisely when and where it thinks best, while carrying very little legacy burden.

So which will do best? I’m still pretty confident of Lloyds’ future and I’m happy to keep holding, but I really can see a very good long-term future in store for Virgin Money shareholders too. Why not buy both?

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Alan Oscroft owns shares of Lloyds Banking Group. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.