Legal & General (LSE: LGEN) shares are one of the most popular investments in the UK today. It isn’t hard to see why – they offer a dividend yield of around 9%.
There’s no such thing as a free lunch in the investing world however. And the potential risks here were brought to light in a recent research note by broker Jefferies.
A major downgrade
In this research note (posted on 5 May), analysts Derald Goh and Philip Kett downgraded Legal & General shares to an Underperform rating. They also lowered their price target to 185p (which implies that the company could lose around £3.8bn in market-cap).
The main reason the analysts are bearish on the insurer is to do with its net surplus generation (NSG) – a measure of free cash flow. They believe that in the years ahead dividend payments will consume roughly all of the company’s NSG, leaving no room for balance sheet strengthening, buybacks, or other endeavours.
Given this weak NSG set-up, the analysts believe that the shares will face a valuation reset as investors focus on stronger names in the sector (such as Aviva). Note that their new price target of 185p is about 27% below the current share price.
If this target was to be hit, investors buying the stock at current levels could be underwater for a while. It would take about three years worth of dividends just to break even (assuming that dividends aren’t reduced).
Should investors be worried?
Now, of course, this is just one firm’s view on the stock. Other firms are more optimistic in relation to the outlook for the insurer’s shares. Personally though, I do see a few risks when I look at Legal & General. For a start, the sky-high dividend yield is a bit of a red flag.
This is signalling that large institutional investors are avoiding the stock (if they liked it they would buy it and this would push its yield down). They obviously see something under the bonnet that they don’t like.
Another issue is dividend coverage (the ratio of earnings per share to dividends per share). It’s currently close to one, which suggests that a dividend cut is a real possibility in the years ahead.
There’s also the fact that Legal & General operates in a very competitive industry. And it’s competing against some far more powerful players (eg BlackRock).
Worth the risk?
That said, there are plenty of things to like here. One thing I like is the company’s diversified business model. This isn’t just an insurer. Instead, it’s a broad financial services company that offers solutions in relation to investment management, retirement and insurance.
I also think the valuation’s reasonable (even if Jefferies analysts expect a reset). At present, the forward-looking price-to-earnings (P/E) ratio is only around 10, so it isn’t an expensive stock. Note that if we take next year’s earnings forecast, the P/E ratio falls to 9.5.
I just think that investors need to be careful with this big name, given the risks. The shares could be worth considering, but I would think about keeping position sizes relatively small. After all, if a dividend yield looks too good to be true, it usually is.
