Lloyds Banking Group PLC’s 2 Greatest Weaknesses

LLOYWhen I think of UK-focused financial services and banking company Lloyds Banking Group (LSE: LLOY) (NYSE: LYG.US), two factors jump out at me as the firm’s greatest weaknesses and top the list of what makes the company less attractive as an investment proposition.

1. Lack of earnings’ visibility

Think of a bank, any bank. Now, tell me how it makes its money. Chances are, unless you happen to be a banking industry professional, you won’t be able to sit me down and explain the workings of the myriad earnings’ streams of a modern international bank.

Sure, you’d have a good stab at explaining banking basics: the bank pays depositors less than it charges borrowers in interest and pockets the difference and, because the margin is small, it leverages its operations up to make the gain meaningful. You’d be right, of course, but the world has moved on considerably from Captain Mainwaring’s day, and such a basic banking business model is rarely all you get if you invest in a bank like Lloyds.

Just look at some of the things that have blown up for banks in recent years: derivatives trading losses, Libor manipulation, sub-prime mortgages and securitised mortgage products, and the mis-selling of payment protection insurance, identity theft, credit card fraud protection and interest-rate hedging products … The list goes on and on and, in most cases, most people are unaware in the existence of such money making practices until the scandal breaks.

I’m not saying Lloyds has been involved in every dodgy activity in the banking world but, because I can’t see what’s going on in the business, the bank is not a viable investment prospect to me. I think Lloyds is more black box than black horse, and I’m sure others might feel the same way.

2. Cyclicality

Can any industry be more cyclical than the banking industry? Shares in Lloyds Banking Group have had a decent run up lately as the firm recovers from its cyclical lows, but I think the big annual share-price rises are probably in the bag and it’s back to normal times ahead. So what is normal for a bank like Lloyds?

To answer that question we need to separate mentally the business of Lloyds from the shares of Lloyds. The business seems set to move up, increasing its earnings year on year as the macro-economic picture improves. The shares seem set to counter that steady improvement, factoring in improving forward earnings predictions by derating the forward P/E rating in anticipation of the next earnings peak, which will lead the next down-leg in the general-economic cycle. Meanwhile, dividends seem set to rise and the dividend yield looks like growing — until the cycle starts going down, which is likely to take the dividend with it.

Of course, things may not work out exactly as my crystal ball tells me, but it’s a reasonable model to use when framing assumptions in the banking sector. In the interests of keeping my investing simple, the issues explored in this article are enough to keep me out of the sector at this point in the cycle.

What now?

After the ructions of the last cyclical low, the banking industry looks as if it has settled down again, which puts the shares of banks like Lloyds back on many investors’ shopping lists.

However, I'm looking at a Motley Fool wealth report that identifies five firms with strong, defensive financial characteristics.

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Kevin does not own any Lloyds Banking Group shares.