Should I be worried that Lloyds shares might drop again?

Lloyds shares are up 15.5% over the past month and still look cheap. But how do I know the stock won’t start trending downwards again?

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I’m still bullish on Lloyds (LSE:LLOY) shares. Despite recent gains, the British bank has beaten expectations in terms of earnings and trades at 22.1% below its average analysts target price. These are excellent signs.

But the stock market doesn’t always work in the way we expect. Lloyds shares, despite appearing undervalued for some time, have demonstrated considerable volatility in recent years.

So is now a good time to buy Lloyds shares?

Earnings excite

In February, Lloyds gave investors something to smile about, announcing a 57% increase in full-year profits and revealed plans for another £2bn share buyback.

For the 12 months to 31 December, pre-tax earnings came in at £7.5bn. The full-year dividend was also increased by 15% to 2.76p per share.

The bank’s net interest margin — the difference between lending and savings rates — expanded 17 basis points to 3.11% in 2023.

However, there was a decline in both the net interest margin and profits in the final quarter amid changes in mortgage pricing and deposit mix.

Moving forward however, Lloyds set aside £450m for a regulatory investigation into UK motor financing. While this isn’t positive, the figure set aside is much smaller than many analysts had been anticipating.

For 2024, the bank expects the net interest margin will fall by 2.9% and forecasts returns of 13%. That’s down from the 15.8% in 2023. However, this is expected to rebound to 15% by 2026.

The risks

Lloyds operates almost entirely in the UK. In fact, around 65% of its income comes from the UK mortgage market and it doesn’t have an investment arm like many of its peers. This means it’s very interest rate sensitive, but also less diversified.

In turn, this means Lloyds is more exposed to a potential downturn in the UK economy. But, more broadly, it’s exposed to the UK’s slow pace of growth.

I’m still bullish

There are several reasons I remain bullish on Lloyds. Firstly, the bank hasn’t seen many ill effects on rising interest rates. It’s been a net beneficiary as impairment charges on bad debt have been lower than expected, partially reflecting the higher income status of its mortgage customers.

And as interest rates start to fall, there should be another tailwind. Banks practice hedging, which is essentially them buying high-yielding assets like bonds, and selling fixed-rate mortgages. Lloyds’ hedging could be worth more than £5bn in revenue next year.

And finally, the numbers just work. Lloyds’ forward dividend is around 6% and the stock still trades at 6.4 times earnings, far below what you’d expect from an American bank. And while earnings may show some weakness is 2024, they’re due to pick up again in 2025 and 2026.

So if the British economy turns out to be weaker than expected, or inflation higher, we could see some pullback. But as a long-term investment, for me, Lloyds looks solid.

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.

James Fox has positions in Lloyds Banking Group Plc. The Motley Fool UK has recommended Lloyds Banking Group Plc. 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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