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3 reasons I’d sell Lloyds Banking Group plc

Image: www.moneybright.co.uk Licence: creativecommons.org/licenses/by/2.0/

As arguably the healthiest of the big domestic banks following the financial crisis Lloyds (LSE: LLOY) has been a relatively safe haven for investors seeking exposure to the sector. However, with low growth prospects, low profitability and an unattractive valuation, I would be reconsidering my ownership of Lloyds if I were a shareholder.

Low growth

Lloyds’ management team was correct to refocus the lender on its core retail banking division following the financial crisis.However with a huge share of the market there’s little room for the bank to grow its top line. For example, Lloyds is the UK’s biggest mortgage lender and is the largest domestic provider of current accounts with 22m customers. This scale is great and points to Lloyds’ continued dominance of the domestic retail banking industry, but it also means there’s little way to grow core revenue by any meaningful degree.

The bank knows this and went out and bought the MBNA credit card business for £1.9bn late in 2016. The credit card sector does involve higher margins than boring old retail banking activities, but it also entails a far greater degree of risk. And Lloyds isn’t the only one targeting the industry for growth, which means it’s facing high competition and is already being forced to offer significant deals to entice new consumers. £1.9bn was also not an insignificant purchase price and with high degrees of risk, plus plenty of competition, it remains to be seen whether this deal will prove more rewarding than simply retuning the money to investors.

Low profitability

In the first nine months of 2016, Lloyds’ underlying profits fell 4% year-on-year to £6bn. It must be said that some of this was due to external headwinds outside of its control, namely rock-bottom interest rates that crimped how much it could charge borrowers. But another, even bigger, factor was continued high operating costs relative to total income.

Although Lloyds’s cost-to-income ratio is better than competitors, it remained quite high at 47.7% in the first three quarters of 2016. While this is a 0.3% improvement on the same period a year earlier, it’s still unclear whether deep cost savings can be found without dramatically trimming the number of branches it operates, which would likely prove unpopular with customers.

Fully valued

Shares of Lloyds currently trade at 1.11 times tangible book value, which is ahead of the sector average of 1.05 times and suggests investors are expecting to see a bit of growth in the coming years. But due to the aforementioned problems, analysts are also forecasting earnings to decrease for each of the next three years. This leads me to believe that should earnings indeed fall and so spook those investors looking for safety, Lloyds shares could likewise head south.

This would be a particular problem if falling earnings due to increased capital requirements, an extension to PPI mis-selling claims, or any other number of potential pitfalls imperil expected dividend increases. At the end of the day, Lloyds is a highly cyclical stock and its lofty valuation and stagnating profits even during the peak of the economic cycle mean I’ll be steering well clear of the bank’s shares.

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Ian Pierce has no position in any shares mentioned. 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.