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Why Lloyds Banking Group plc Is A Better Buy Than HSBC Holdings plc & Virgin Money Holdings (UK) PLC

Here at The Motley Fool, many authors (including myself) are huge fans of Lloyds Banking Group (LSE: LLOY). I would like to think that we like it for good reasons, too. Profitability at Lloyds is returning to healthy levels, its balance sheet has been strengthened and the bank looks set to return to regular dividend payments.

However, critics point out that Lloyds’ shares trade at a premium to many of its peers and hefty PPI provisions continues to drag on earnings. In addition, the bank is highly exposed to the UK property market and is vulnerable to a rate hike by the Bank of England. Nevertheless, I still think the outlook for Lloyds remains positive, and it is a better buy than HSBC (LSE: HSBA) and Virgin Money Holdings (LSE: VM).

Domestic Scale vs Global Diversification

Domestic focus and global diversification are generally considered two distinct banking business model. Banks adopting the domestic focus model rely on building scale in one key market, in order to benefit from local economies of scale. This is of particular benefit in retail banking and Lloyds and Virgin Money are very much in this category.

On the other hand, HSBC is adopting the global diversification model. This strategy focuses on reducing earnings volatility by spreading risks across the world and taking advantage of global economies of scale. Global economies of scale are usually most beneficial for investment banking and wealth management markets.

Although both business models have their own advantages and disadvantages, domestic focus is generally the preferred model by many analysts today. Ever since the recession, banks with local scale have typically been more profitable, which explains why the shares of most domestically focussed banks trade at a premium to their diversified peers.

ROE and Valuations

When comparing between different banks, the most commonly used financial metric is the return on equity (ROE). This is because, bank that have higher ROEs (i.e. the more profitable ones) typically deserve to trade at more pricey valuation multiples.

 

Return on equity

(2015 estimate)

Price-to-book

Forward P/E

(2015 forecast)

Lloyds 15.3% 1.32 8.6
HSBC 8.2% 0.81 9.9
Virgin Money 8.0% 1.22 15.2

Here, we see why Lloyds trades at a higher price-to-book value than its two competitors. The greater profitability of Lloyds, as reflected by its return on equity, means it can generate more profit for every £1 in equity the bank holds. And, it is also important to note that although the bank trades at a premium on a price-to-book basis, it is actually cheaper than its two competitors on a forward price-to-earnings basis.

Another interesting point is that although Virgin Money is one of the larger challenger banks, it is not very profitable. This is partly due to the fact that it is holding excess capital, which it has yet to deploy efficiently. But this can be viewed as a positive, as it means the bank can afford to grow its loan book more quickly and pay greater returns to shareholders.

Near-Term Catalysts

Critics are concerned that provisions for legacy misconduct issues, most notably, PPI provisions, remain stubbornly high. And, this could continue to hurt the bank’s “actual” profitability and restrict the amount of capital available to make dividend payments. However, I see potential positive catalysts that should reduce the level of provisions going forward. PPI claims are already beginning to decline and the FCA, the UK financial regulator, has proposed to set a deadline for further claims by 2018.

Another positive for Lloyds (and Virgin Money) is the robustness of the UK economy and the property market. Although exposure to just one market is risky, the timing for being exposed to the UK market couldn’t get any better. Growth in much of Europe and Japan is sluggish, whilst emerging markets are slowing down fast. This will likely act as a drag on earnings growth for HSBC, as loan losses are projected to rise, whilst the bank would struggle to find new lending in a downturn.

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