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How Lloyds Banking Group plc could boost your investing profits

Photo: moneybright.co.uk Cropped. Licence: https://creativecommons.org/licenses/by/2.0/

Lloyds Banking Group (LSE: LLOY) grabbed headlines last week with news that its 2016 pre-tax profit was “more than double” the figure from 2015.

But these statutory — or reported — figures include the impact of exceptional items such as misconduct fines and PPI compensation.

The bank’s underlying figures strip out these items in order to provide a picture of its performance before these exceptional costs. And what Lloyds’ underlying figures showed last week is that the bank made less profit in 2016 than it did in 2015. Underlying pre-tax profit was £7,867m last year, down by 3% from £8,112m the previous year.

What’s really happened?

What’s really changed is that Lloyds’ misconduct charges were much lower in 2016 than in 2015. The main reason for this is that the money spent on PPI compensation fell from £4bn to £1bn last year.

When other misconduct charges are also included, the cost of Lloyds’ past mistakes was £2.7bn lower in 2016 than it was in 2015. This is almost a direct match for the £2.6bn increase in reported profit last year.

It’s not safe to ignore this

Of course, the money paid out as PPI compensation is real cash. It has eaten away at Lloyds’ profits in recent years and can’t be ignored.

My point is that the bank’s profits have been crushed by its past mistakes. It’s the same for investors. Having a couple of 100%-plus winners in your portfolio is not worth much if you also have stocks that fall by 90%. The profits from your winners will be cancelled out by your losses.

Warren Buffett once said that his number one rule of investment is “never lose money”. By focusing on what could go wrong with a potential investment, you can often avoid future losses. This means that you’ll get the full benefit of your most profitable buys.

What about Lloyds — is it a buy?

Although Lloyds’ flat earnings might seem discouraging, I see this simply as a sign of the times. Ultra-low interest rates make it difficult to grow profits in a mature bank.

Lloyds slowed down its mortgage lending last year to protect its profit margins. The bank is hoping that its recent acquisition of MBNA’s UK credit card business will provide some growth instead.

However, the current situation won’t last forever. Interest rates are unlikely to fall any lower and may well rise over the next few years. Lloyds’ ability to generate surplus capital for dividends in the current market suggests to me that profits could rise sharply with higher interest rates.

The main downside risk is Lloyds’ position as the UK’s largest mortgage lender. A surge in interest rates and a housing crash would undoubtedly hurt the bank. But with the shares trading in line with their book value and offering a 2017 forecast yield of 5.1%, I think some downside risk is already in the price.

My personal view is that Lloyds’ remains a long-term income buy at current levels.

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Roland Head 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.