Over the past year, shares in Lloyds (LSE: LLOY) have moved up roughly 15% in price. At the moment, I can buy them for around 51p each. Would that make sense for me as an investor?
The good news
Let’s start by considering some of the positive aspects of the bank’s investment case.
Lloyds is a leading bank and has a domestic focus. That means that it can do well from its strong position in the UK market. It also helps avoid some risks faced by more internationally exposed rivals with large operations beyond retail banking, such as Barclays and HSBC.
The company is the biggest mortgage lender in the land. That helps it benefit from a market that combines strong housing demand, high prices and low default rates. Those elements add up to a recipe for large profits. Last year, the company reported post-tax profits of £5.6bn. So Lloyds shares selling at 51p apiece are trading on a price-to-earnings (P/E) ratio of 7. That is a potentially cheap valuation, in my view.
On top of that, Lloyds shares each pay an annual dividend of 2.4p. At the current share price, that equates to a 4.9% dividend yield.
The bank chooses not to pay out most of its profits as dividends at the moment. So not only is the payout well covered, there is substantial room for dividend growth, even if profits are stagnant.
Worsening outlook
Last year though, profits were not even stagnant. They fell. A large share buyback programme means that earnings per share fell less in percentage terms than total profit. But the picture is the same. A worsening performance.
I see a risk that trend will continue. The economy is not in great shape and inflation means many household budgets are increasingly stretched. That could lead to higher default rates. In the bank’s most recent quarter, it set aside an impairment charge for an expected increase in the number of defaults, although it emphasises that the observed increased in defaults remained “small”. The bank said that so far it is seeing only “very modest evidence of deterioration” in repayments on its loan book.
Still, the risk of higher defaults is a critical one for a bank. If that happens, Lloyds shares may not end up looking cheap after all.
Profits could fall again, the P/E ratio will rise as earnings fall and dividends could ultimately be at risk if profits are hurt badly enough. The Lloyds dividend was suspended for six years following the financial crisis. Even today, it remains far below what it was before that crisis. It is also still well below its pre-pandemic level, even after the recent 20% increase in the annual payout.
I’m not buying yet
So although I see strengths in the Lloyds business, I continue to be wary of the risks facing the bank in the present economic environment.
I think a 51p share price might turn out to be a bargain – but if defaults rise, buying now could ultimately be a costly mistake on my part. So I have no plans to add Lloyds shares back into my portfolio at the moment.
