Why I’d Buy Lloyds Banking Group plc And Less Well Known Shawbrook Group plc and Aldermore Group plc

When I cast my Foolish eye across the market, I am often struck by what can only be described as a short-term foolish reaction to an ill-received set of results. We have seen this type of behaviour with several companies unfortunate enough to disappoint the market during the market volatility. It is fair to say that some share prices were rightly punished, while investors have been left scratching their heads with others.

However, as some traders head for the exit, those patient enough to see the bigger picture and sit tight through the volatility can be richly rewarded over the long term. Both in terms of capital and rising income.

Banking on a recovery

I believe that investors that are happy to buy and hold shares in Lloyds Banking Group (LSE: LLOY) could well be laughing all the way to the bank, as management continues to shape this slumbering giant into a UK-focused retail and commercial operation.

While it is true that investors were disappointed with further provisions for past PPI misdemeanours and below-forecast performance in the third quarter, management pointed to a strong balance sheet and liquidity position, with a Common equity tier 1 (CET1) ratio of 13.7% versus 13.3% as at 30 June – that’s a strong position to be in. Additionally, costs continued to shrink towards the 2017 target of 45%

And for the income seekers out there, analysts are pencilling in a well covered 3% plus dividend yield for the year ending 2015, and a twice covered 5% yield to be had in 2016. I’m happy when I’m paid to wait!

Rise of the challenger banks

One thing that management at Lloyds would love to be able to do is start with a clean slate. This is exactly what is happening with two sub-billion market cap challengers. Both Shawbrook (LSE: SHAW) and Aldermore (LSE: ALD) both came to market in the first half of this year. As we can see from the chart, both are easily beating the FTSE 100 and their larger peer.

Shawbrook, a specialist lender and savings bank, has accumulated a near £3bn loan book since it was created in 2011. The Company provides loans to the United Kingdom’s small and medium-sized enterprises and consumers. Its Commercial Mortgages division provides mortgages for residential investors, short-term loans for property professionals and commercial property loans for seasoned investors and owner-occupiers.

Analysts are positive on the stock, with net earnings expected to rise to £60m in 2015 and to over £80m in 2016. This puts the shares on a forecast P/E of just over 11 times earnings. Additionally, the bank is expected to enter the dividend list in 2016, and whilst an expected 1% yield isn’t the best on offer in the market, it should be a good base to start from.

Aldermore Group plc was established in 2009 and focuses on specialist lending to small and medium-sized enterprises (SMEs) and homeowners. The Company’s lending segments include asset finance, invoice finance, SME commercial mortgages and residential mortgages. It is funded through online retail and SME deposits.

As with Shawbrook, the investment community has a positive view of the shares, with analysts steadily upgrading their forecasts over the last twelve months. For the year to 2015 the market is expecting net profit to almost double, then rise by nearly 20% for 2016 — and I wouldn’t be surprised to see this rise further with the UK economy in good shape. While there isn’t a dividend expected till 2017, it could well pay to get in early as there seems to be plenty of growth on offer, which makes it an attractive proposition in my view.

Summing it all up

Here we have three profitable banks, one transforming itself into a leaner lender while dealing with its legacy issues and set to yield over 5% in time, and two smaller peers that look set to grow quickly and start to distribute some of those profits to shareholders via dividends.

For those of us searching for yield, one of the best tried and tested methods is to adopt an approach towards a more diversified portfolio, tailored towards good solid income producing stocks - the sort that will make money whatever the weather.

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Dave Sullivan has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.