Lloyds (LSE:LLOY) shares have seen solid gains since the beginning of 2023. But this recent rally means the stock is only up 2% over one year and using metrics like the price-to-earnings (P/E) ratio, Lloyds trades at a multiple (seven) roughly half the index average (13.8).
I don’t believe it deserves to be this cheap. But as a value investor, I’m quite content. After all, super-investor Warren Buffett says net buyers should celebrate down markets, just as we might take advantage of lower food prices.
So, let’s take a closer look at why Lloyds might be undervalued, and why I think it could be a big winner in the coming years.
Unloved
I’d argue that Lloyds is somewhat unloved. Investors are clearly wary, which is also the case with other UK-focused banks.
Naturally, in the short term I can see that the outlook for the UK economy isn’t overly positive. In fact, we’re the only G7 nation forecast by the IMF to experience a recession in 2023.
Banks typically reflect economic conditions. When economies go into reverse, bad debt increases and banks have to improve their provisions for defaults.
Historically, there may be more reasons for Lloyds trading with a P/E half the index average. Some investors may still remember the devastation of the financial crash and be put off by the restrictions placed on banks following the crash. Others may be concerned about the impact of Brexit on long-term prospects.
Reasons for optimism
The general environment that has surrounded the sector in recent years is changing. We’re moving from a relatively low growth and low interest rate environment, to a higher interest rate, and possibly negative growth one.
The higher rates issue is particularly important. With the Bank of England (BoE) pushing rates upwards, Lloyds expects its net interest margin to come in above 2.9% for full-year 2022. That’s up from 2.5% at the end of the prior financial year.
It’s even earning more interest on its central bank deposits. It had £145.9bn of eligible assets with £78.3bn held as central bank reserves at the end of Q2. Analysts suggest each BoE 25 basis point hike will add close to £200m in treasury income solely from holdings with the central bank.
Through hedging strategies and fixed interest rate offerings, these higher rates should spread gains out over a longer period of time. A five-year fixed rate today is far above the average for the last decade.
Yes, higher rates and a recession will likely mean more impairment costs. But evidence suggests higher net interest income will more than offset increasing impairment charges in the long run.
Moreover, greater near-term revenue generation should provide banks with more capital for a host of projects that haven’t been feasible over the past decade. For example, through the brand Citra Living, Lloyds intends to buy 10,000 homes by 2025 and 50,000 homes by 2050.
Why I’m buying more
The aforementioned reasons for optimism underpin my faith in Lloyds and are why I’m buying more. But I’m also buying for the dividend. Currently the yield stands at 3.8%. That’s nothing special. However, City analysts are forecasting a full-year dividend of 2.4p in 2022, rising to 2.7p and 3p in 2023 and 2024 respectively. That would represent a 6.2% forward dividend yield for 2024.
