The idea of selling shares in Lloyds Banking Group (LSE:LLOY) for almost £1 a go must have felt strange to investors when the stock was at 35p in 2020. But it’s close to a reality now.
With the stock down this week, investors might be wondering whether it’s a good idea to take profits and redeploy them elsewhere. And I don’t think that’s a bad thing to consider.
Cyclicality
As a retail bank, Lloyds is a pretty cyclical business. Its fortunes are closely tied to interest rates and the strength of the underlying economy – specifically, consumers.
This means investors need to try and assess where in the cycle the company currently is. And they need to think about whether or not this is reflected in its share price.
In general, cyclical stocks should trade at lower price-to-earnings (P/E) ratios when things are going well. The chance of things going wrong is higher and there’s a risk of falling earnings.
By contrast, investors might expect to find higher multiples during a downturn. There’s a good chance things will pick up in a recovery and earnings will be higher without the firm doing much.
What investors really don’t want to see is a stock that’s priced like it’s at a cyclical low when it’s actually not. In other words, a high P/E ratio for earnings that could be at risk.
Lloyds has spent most of the last five years with a P/E ratio of 6 at a time when interest rates were low. But it’s now trading at a multiple of 12 and rates have been much higher.
What goes up…
I’m not a big fan of selling stocks just because they’ve gone up. But with cyclical stocks, I do think investors need to pay attention to where they are in a cycle.
In some cases, the risk of selling too early is much lower than the potential danger of holding on for too long. A good example is Croda International – the FTSE 100 chemicals company.
Croda benefitted during Covid-19 from a surge in demand for its products. This was partly due to vaccine sales, but high crop prices also boosted demand in its agriculture division.
Investors were able to see this in real time. The stock went up 36% between November 2019 and November 2020.
Shareholders who sold at that point missed out on another 60% as the stock immediately went higher. But things have changed since then and anyone still holding is down 57% in five years.
Obviously, it would have been best to sell the stock when it was at its all-time highs. But nearly nobody can work out when this is and being early is sometimes better than being late.
Foolish thoughts
Investors don’t need perfect timing to do well with cyclical stocks. They do, however, have to think about the company’s future earnings in relation to its share price.
In the case of Lloyds, a P/E ratio of 12 isn’t the most demanding in the FTSE 100. But it’s higher now than it was at a time when interest rates were much less favourable.
That makes me wary with the stock right now. My sense is that shareholders who have big unrealised gains might want to think about using some of those to diversify into other opportunities.
