Why Lloyds Banking Group PLC Is Set To Rule The Footsie In 2016

Suffice it to say, 2015 hasn’t been a great year for Lloyds (LSE: LLOY) and the bank’s share price performance reflects that. It’s fallen 6.5% since the turn of the year and that’s after 2014 was also a poor year for Lloyds when its shares declined 4%. Investors could be forgiven for anticipating yet another tough year ahead for the part-nationalised bank.

But that could be a mistake. In the last couple of years Lloyds has been making gradual improvements to its business that have set it up for excellent long term performance. It disposed of non-core assets where it felt the risk/reward ratio on offer wasn’t appealing and this has allowed it to concentrate on developing its core assets and generating efficiencies from them. With Lloyds having a cost:income ratio of just 48% in its recent third quarter results, it’s clearly moving in the right  direction following major job losses and cost-cutting initiatives.

Although tough in the short run, such changes to Lloyds’ business model have returned the bank to profitability. And with the government’s stake gradually being sold down, it’s clear Lloyds is almost ready to live without state aid. This process is set to be completed next year when Lloyds is offered to the public at a 5% discount to its market price and with the promise of a free share for every 10 held for at least one year.

Such an offer is likely to stimulate demand for Lloyds’ shares next year and with the bank trading on a price to earnings (P/E) ratio of just 8.5, there’s tremendous scope for an upward rerating in 2016 and beyond.

Additionally, Lloyds is benefitting from an improving UK economy and even though interest rate rises have the potential to act as a brake on the macroeconomic outlook, the reality is that they’re likely to rise at a very slow pace. In fact, with the price of oil falling and pushing inflation lower, the Bank of England has little scope for anything more than a token rise in interest rates at the present time. This should help to stimulate demand for new loans as well as making life easier for those individuals and businesses needing to service their existing loans.

As well as the potential for rising profitability, Lloyds’ dividend potential is likely to convince many investors that it’s a worthy purchase in 2016. Lloyds may only yield 3.4% at the present time but it’s expected to yield 5.2% in 2016 and with a rumoured payout ratio goal of 65% over the medium term, dividends could rise at a rapid rate. This, combined with a continued low interest rate, could make Lloyds one of the most in-demand income stocks in the FTSE 100.

So while the last two years have been disappointing for Lloyds, in 2016 it’s set to rule the FTSE 100. After all, with a higher yield, lower valuation and brighter growth prospects than the index it looks like a sound long term buy at the present time.

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Peter Stephens owns shares of Lloyds Banking Group. 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.