A banking stock I’d buy alongside the Lloyds share price

Should you invest in Lloyds Banking Group (LSE: LLOY) or a challenger bank? Here’s why I see both as buys.

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The financial crisis wasn’t kind to the banks, and Brexit has only complicated the uncertainty.

But when a well-established clique of companies is thrown to the wolves, that does a good thing – it exposes weaknesses and opens the door for those that can do better. The challenger banks have benefited, and today I’m looking at Paragon Banking Group (LSE: PAG).

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Specialist lending

Paragon focuses on specialist lending markets, and its buy-to-let coverage has attracted negative sentiment, as my colleague Harvey Jones has noted. But though that market is falling out of favour with private investors, the professional segment is robust and I expect it will remain that way.

In full-year results released Tuesday, chief executive Nigel Terrington said: “We are delighted to report another excellent financial and operational performance, underpinned by our effective diversification strategy and focus on specialist lending. Volumes, profits and dividends are up strongly, and we are moving closer to our medium-term target of over 15% return on tangible equity.”

The company reported an 8.5% rise in lending volumes to £2.53b, leading to a 5% rise in underlying pre-tax profit to £164.4m.

Retail deposit balances rose by a big 20.7% to £6.39b, indicating a solid balance sheet. Paragon was able to report a common equity Tier 1 ratio of 13.7%, which is healthy and looks consistent – a year ago, the same measure stood at a near identical 13.8%.

The dividend was lifted 9.3% to 21.2p per share, for a yield of 4.2%. That’s not the biggest in the banking sector, but it does represent a near-doubling from the 11p paid out in 2015. Looking at forward price-to-earnings multiples of under 10, I see Paragon as a long-term buy.

Big banks

Does that mean I’m bearish on our big FTSE 100 banks? Not a bit of it, and I’m still very happy with my holding in Lloyds Banking Group (LSE: LLOY).

What are Lloyds’ strengths? For me it’s essentially that we’re looking at a domestic-focused bank these days (after the inevitable loss of London as Europe’s main banking centre), but one that is showing growing profits, strong cash flow, and a healthy balance sheet, and which is paying handsome dividends. Oh, and the shares are on a very low P/E rating.

While the Lloyds share price has stagnated, I’ve kept on taking my dividends with a smile on my face, and I’m looking forward to reinvesting the 5.6% I’m likely to receive this year. But I really would like to see an improvement in the stock’s forward P/E valuation of only eight, so what would that take?

Politics

It seems clear that it’s all down to what happens politically in the next few months.

I reckon Boris Johnson is likely to win the election with a working majority, and will be able to get his latest Brexit deal through Parliament. And though I think the man lacks integrity and I wouldn’t trust him an inch, I see him as likely to be far less damaging to the economy than Jeremy Corbyn.

It’s a sad state of affairs, politically, when we have to pick the least worst option – but hopefully it will presage an uptick in stock market confidence, with Lloyds, specifically, getting back to business as usual.

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Alan Oscroft owns shares of Lloyds Banking Group. 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.

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