At 42p, are Lloyds shares a bargain or a value trap?

There are two cases to be made for the Lloyds share price. Here, I weigh the pros and cons of an investment in the banking stock right now.

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The Lloyds (LSE:LLOY) share price is suffering along with other top finance shares in the UK. Rampant inflation is forcing global economies to raise interest rates. Today, news broke that the US government is considering another increase after it rolled out its largest hike in 28 years just last month. Here in the UK, the Bank of England has suggested that inflation could hit 11% in October.

And now, a new Covid lockdown in China is rekindling concerns from 2021. This could trigger another mini-collapse, causing shares to dip further. But I think preparing for a crash is the best investing strategy I have learnt in the last two years. Given the current economic climate, should I consider adding cut-price Lloyds shares to my portfolio if markets slide further? 

The bull case 

Yes, interest rate hikes mean banks will generate more cash on past and future loans. And for Britain’s largest lender, this is a welcome boost. And the recent analyst estimates for Lloyds look flat but I also see some positives. 

Currently, the estimates suggest that overall annual revenue from 2022-26 will remain between £4.5bn and £4.7bn. This tells me that the overall cash flow could remain stable, which is a good sign for Lloyds’ dividend. And Lloyds shares receive high investor interest throughout the year, largely thanks to its robust 4.75% dividend yield. 

Another positive I see over the next few years is an increase in business loans. Historically, periods of inflation have led to higher rates of borrowing among small and medium-sized businesses. And this ties in well with free cash generated. The Lloyds dividend has an earnings cover of 3.7 times, which is a strong sign that the company can sustain its current yield. And given the estimates for the next few years, I think I can expect a steady payout from Lloyds shares, which would make it a bargain on paper.

The bear case

While banking stocks stand to earn from more than one source, increased interest rates are not a good sign for the UK economy. Consumer goods brands are already seeing smaller baskets and measured spending as budgeting becomes a priority. And the housing boom in the UK looks like it is slowing down. This is bad news, particularly for Lloyds shares. 

We could just be entering a cyclical housing bear market in the UK after a decade of high demand. Lloyds bank earns a major chunk of its revenue from housing mortgages and it also recently invested in residential plots in the UK. This move could easily backfire with a housing collapse. And the Lloyds share price could fall as a result, which puts my investment at risk of falling into a value trap. 

The current instability is a big red flag for me and is keeping me from investing in any finance share in the FTSE 100. Yes, I think Lloyds is a strong business that will continue to generate cash for the foreseeable future. But other exciting areas are cropping up in the UK that could be better for my portfolio. I am looking at some top UK energy and tech shares right now. And I am steering clear of Lloyds and other finance stocks at the moment while looking for signs of a recovery.

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.

Suraj Radhakrishnan has no position in any of the shares 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.

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