In the last month, Lloyds (LSE: LLOY) has fallen by 9%. This could lead investors to feel that it’s a stock to avoid because more share price declines could lie ahead. However, Lloyds now offers better value for money and could be subject to a significant upward rerating.
Of course, Lloyds faces a major risk. Brexit is due to be the biggest political change in the UK’s recent history and could cause the economy to endure a very challenging period. Certainly, the Bank of England believes that the UK’s growth outlook has deteriorated since 23 June. It now expects only marginal growth in 2017 as well as a higher unemployment rate.
As a UK-focused bank with large exposure to the mortgage market, this could cause a headache for Lloyds. Default rates could increase on existing loans and demand for new loans could plummet. Therefore, further share price falls can’t be ruled out over the short-to-medium term.
And the pros…?
However, the dangers facing Lloyds will be offset to at least some degree by an increasingly loose monetary policy. The Bank of England has already cut interest rates to 0.25% and it would be unsurprising for them to fall to 0.1% in the coming months. Further quantitative easing is also on the cards and this could continue to support high asset prices.
While Lloyds faces a very uncertain outlook, it offers a wide margin of safety. This reduces the risk profile of the bank and means that even if its financial performance disappoints, Lloyds could still perform relatively well as an investment. For example, even though Lloyds’ bottom line is forecast to fall by 14% in the current year and by a further 13% next year, it still trades on a forward price-to-earnings (P/E) ratio of 8.4. Even in a cheap wider banking sector, Lloyds has value appeal.
Furthermore, Lloyds is quickly becoming a very strong income play. In the current financial year it’s due to pay dividends of 3p per share, which puts it on a yield of 5.6%. This is 190 basis points higher than the FTSE 100’s yield. Lloyds’ dividend is set to be covered 2.4 times in the current year, which shows that there’s scope for a rising dividend over the medium term.
In fact, Lloyds is due to increase dividends by 13% in 2017 to 3.4p per share. This means that it has a forward yield of 6.3%, which is among the highest in the FTSE 100. Even though Lloyds’ profitability is forecast to fall next year, dividend headroom is expected to remain healthy as shareholder payouts are covered 1.9 times by earnings.
Looking ahead, Lloyds undoubtedly faces a difficult future. Its earnings are due to fall, Brexit brings great challenges and Lloyds’ share price may remain volatile. However, with a high and affordable yield alongside a wide margin of safety, it remains a sound long-term buy.
