Although it looks cheap, Lloyds could actually be expensive

Why I’d avoid shares in Lloyds Banking Group plc (LON: LLOY) despite its big dividend.

| 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.

I see Lloyds Banking Group (LSE: LLOY) as a bit like a Venus flytrap waiting to capture the unwary investor with the nectar of its high dividend yield. I reckon there’s every chance those buying the firm’s shares because of its dividend could end up disappointed over the long haul as that trap snaps shut!

That may be a colourful analogy, but I believe there are serious risks involved with holding shares in Lloyds that may not be obvious. Justifying an investment on the grounds of the firm’s low valuation could end up getting investors in trouble.

But it looks so cheap!

At the current share price close to 59p, the historical dividend yield stands higher than 5% and City analysts following the firm expect the dividend to move higher during the current trading year and again next year. If things work out as expected, the yield could be around 6% by 2020. And other valuation indicators look low too.

The price-to-earnings ratio is just over nine and is expected to drop to just above seven by 2020. Then there’s the price-to-tangible book value running at close to one. Most indicators you can look at suggest the valuation might be low. But is it? I don’t think so.

My main concern is that Lloyds could be trading close to peak profits for the current economic cycle. Last year’s full-year accounts reveal the firm earned around two-thirds of its income from net interest, with the remaining third from activities such as commercial banking, insurance and wealth management. But I think the one thing all those activities have in common is they can be highly cyclical.

In general, I think the stock market is a clever beast because it represents the opinions and investment actions of thousands of investors, both institutional and private. To me, the current valuation suggests many investors expect profits to cycle lower, as they have done before. If that happens and earnings fall by 50%, say, the current valuation won’t look so low.

But I think the risk is greater than merely a higher valuation. If earnings plunge, there’s a good chance the dividend and share price will follow. Look what happened around the time of last decade’s credit crunch. And before that in the history of the banking sector, crashes are relatively common.

Vulnerable to a downturn in its markets

If you collect dividends from Lloyds for a decade, one good cyclical plunge could wipe out all your good investing work and, to me, that’s a big risk when considering investing in the firm’s shares. A large part of Lloyds’ income comes from the mortgage market and a downturn in that industry, for example, would hit the bank hard.

But it’s easy to become distracted from the cyclical big picture and to get bogged down in over-considering current issues that the bank faces, such as the ongoing payment protection insurance debacle and other matters relating to the banks’ past conduct.

However, I reckon the next crash will likely come just when things look like they’re at their best for the bank. I’m avoiding the shares.

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.

Kevin Godbold has no position in any share mentioned. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Portrait of elderly man wearing white denim shirt and glasses looking up with hand on chin. Thoughtful senior entrepreneur, studio shot against grey background.
Investing Articles

Here’s how much an investor would need in an ISA to earn a £10,000 second income this year (and every year!)

A five figure annual second income from a standing start? Christopher Ruane walks through the approach he's taking towards this…

Read more »

One English pound placed on a graph to represent an economic down turn
Investing Articles

The FTSE 100 hit an all-time high this week — but I still loaded up on this share!

In a ground-breaking week for the index, why has our writer been buying more of a FTSE 100 share that…

Read more »

A senior man and his wife holding hands walking up a hill on a footpath looking away from the camera at the view. The fishing village of Polperro is behind them.
Investing Articles

Here’s how an investor could find shares to buy for an early retirement

Our writer lays out some principles a retirement-focused investor could consider when scanning the market for possible shares to buy.

Read more »

Young mixed-race couple sat on the beach looking out over the sea
Investing Articles

8 pros and cons of buying shares as a passive income idea

Christopher Ruane buys dividend shares to generate passive income streams. Here's his candid assessment of some good and bad things…

Read more »

Investing Articles

Is £280 enough to start buying shares for the first time? Yes – and here’s why!

Christopher Ruane outlines how someone with under £300 available could start buying shares for the first time -- and why…

Read more »

Investing Articles

How an investor could use a Stocks and Shares ISA to target £1,120 in dividends annually

Here's how an investor could target four figures of passive income next year and every year from a £20K Stocks…

Read more »

Warren Buffett at a Berkshire Hathaway AGM
Investing Articles

5 pieces of Warren Buffett wisdom for new investors – and very old ones!

Christopher Ruane identifies a handful of lessons from billionaire investing legend Warren Buffett he uses himself in the stock market.

Read more »

Investing Articles

The 8% yield looks good but the Vodafone share price is still fighting for a recovery

Mark Hartley examines the reasons why the Vodafone share price continues to struggle and what this could mean for investors…

Read more »