How Will Lloyds Banking Group Plc Fare In 2014?

For most shares in the FTSE 100, 2013 was a good year and investors have likely enjoyed capital gains and rising dividend income.

That makes me nervous about investing for 2014 and beyond, and I’m going to work hard to adhere to the first tenet of money management: preserve capital.

To help me avoid losses whilst pursuing gains, I’m examining companies from three important angles:

  • Prospects;
  • Risks;
  • Valuation.

Today, I’m looking at UK-focused financial services and banking company Lloyds Banking Group (LSE: LLOY) (NYSE: LYG.US).

Track record

With the shares at 83p, Lloyds’ market cap. is around £59,500 million.

This table summarises the firm’s recent financial record:

Year to December 2008 2009 2010 2011 2012
Revenue (£m) 16,195 45,297 44,044 26,843 38,906
Net cash from operations (£m) 33,841 (33,735) (2,037) 19,893 3,049
Adjusted earnings per share 10.1p 7.5p (0.5p) (4.1p) (2p)
Dividend per share 11.4p 0 0 0 0

1) Prospects

Lloyds has been one of my biggest investment lessons over the last few years. For that, I thank it. Looking back to the halcyon investment years in the middle of the last decade, Lloyds gave the impression of being a dependable old institution that investors could rely on for a steady stream of gradually rising dividends. “It’s a bank,” went the cry, “What could be safer than investing in a bank? They deal in money, for goodness sake!”

I’ll bet that impression didn’t fool investors with longer memories than me, for if you look back over the last century or so, banks have a regular habit of getting into the kind of trouble that the track record above advertises. So what does that mean, and what is the big lesson that Lloyds and other companies so effectively sunk into my block? Cyclicality, dear boy, cyclicality! Whatever I do investment wise now always starts with assessing a company against the backdrop of its cyclicality and that of its markets. Legendary US investor Peter Lynch is the best source I’ve yet discovered for getting to grips with that investing subject in his book Beating The Street.

In the recent third-quarter interim statement, Lloyds reckoned it is well on the way to becoming a better, simpler, lower risk bank, capable of delivering the products its customers need and the strong, sustainable returns expected by shareholders. The firm has been working hard on its turnaround, cutting costs, refocusing, selling off non-core assets, building up its capital ratios, the normal kind of thing. The figures are good, with underlying profit up 136% on a year ago.

However, the share price has been performing well too and, with the economy firmly returning to growth, it looks like ‘normal’ times ahead for Lloyds. Indeed, the CEO recently said, “We have now commenced discussions with the regulators regarding the timetable and conditions for future dividend payment.” Ahah! Now that does make me nervous about an investment in Lloyds now. Skip back to the top to see why.

2) Risks

I think the big annual share-price rises are probably over for Lloyds in this macro-economic cycle and investor-returns could be less spectacular from here. This is a turnaround that has turned, so what’s the investment proposition now? Well, macro-economic news is becoming increasingly good. We are heading towards the next cyclical peak and banking shares may start to adjust to accommodate peak earnings again, which means investors could see P/E compression and dividend yield expansion. Investors will be attracted to the dividend again; like moths to a flame, some might say.

But for me there’s another risk: I’ll never understand what’s going on in Lloyds’  business until after it has happened, which is too late when it comes to investing, as the share price will already have moved. Banking businesses lack transparency in my world, even though I’ve been investing for years. Banks like Lloyds are definitely outside my comfort zone and I reckon other private investors will feel similarly after trying to analyze the prospects and financial statements of public limited banking companies.

3) Valuation

At 83p, the shares are trading with a 62% premium to the last-reported tangible net asset value. Banks are most attractive when trading at a discount.

The forward P/E rating for 2015 is almost 11, and city analysts expect those earnings to cover a dividend payout around twice that year, implying that the forward dividend yield could be as high as about 4.6%.

What now?

To me, banks like Lloyds Banking Group are less attractive than they were a few years ago, around 2009. Banks are early cycle investments in my view and Lloyds’ big annual share-price up-moves look done in this cycle.

Although there’s still potential for earnings to increase a long way from here, P/E compression could drag on an investors total return result, and sitting in banks is risky when the unpredictable down-leg of the current macro-economic cycle arrives.

That's why I'm looking at potential investments with consistent cash flows whatever the macro-economic cycle is doing, and I think I've found some in a Motley Fool report prepared by our top analysts. The report highlights five shares with the kind of dependable all-season stalwart-like characteristics that Lloyds appears to lack.

These evergreen stock market stalwarts deserve consideration for any investor aiming to build wealth in the long run. The report is available now -- to download your copy just click here.

Kevin does not own shares in Lloyds Banking Group.