Don’t buy Lloyds Banking Group plc, Royal Bank of Scotland Group plc and Aldermore Group plc until you’ve read this

It’s been a roller coaster ride for UK investors since the EU Referendum result. After an immediate market wide panic-driven sell-off, many FTSE 100 stocks have rebounded and surged higher. Yet other stocks, particularly those exposed to the UK economy, haven’t fared so well and the UK banking sector is one area that has suffered heavily.

Lloyds Banking Group (LSE: LLOY), Royal Bank of Scotland Group (LSE: RBS) and Aldermore Group (LSE: ALD) have all seen their share prices slashed post-Brexit and investors might be wondering if now is a good time to buy these banks.

But there are some important issues affecting these three companies that investors should be aware of.

UK exposure

It’s a commonly accepted view that after voting to leave Europe, the UK is likely to struggle economically in the short term. UK GDP growth forecasts have been cut and it’s possible we could see a property market slowdown or recession.

While it’s hard to accurately predict the extent of the Brexit consequences, investors should be aware that any economic downturn will have ramifications for UK banks. That’s because banks are cyclical businesses – they perform well during prosperous times and struggle during downturns.

This explains the sudden shift in sentiment towards Lloyds, RBS and Aldermore as the UK is the main operating market for all three banks. UK income makes up 100% of group income at both Lloyds and Aldermore and 88% of group income at RBS. This is in contrast to Barclays (48%) and HSBC (25%), which have more diversified global operations. 

Broker downgrades

Another thing to be aware of is that many analysts have been quick to downgrade the UK-focused banks after the referendum and some of the downgrades have been brutal.

For example, Citi has slashed earnings estimates at Lloyds by 7% for 2017 and 20% for 2018 and has downgraded the bank from neutral with a 73p price target to sell with a 52p price target. Similarly, analysts at Jefferies have cut their price target for Lloyds from 108p to 68p, while Bernstein’s price target for the bank is a low 40p. Société Générale still rates Lloyds a buy but has stated that dividends could be affected as the bank may face higher impairments in the wake of Brexit.

It’s a similar story for RBS, with several sell-side analysts cutting their price targets for the bank in the last week. And challenger bank Aldermore hasn’t escaped the carnage with Citi reducing its price target from 210p to 140p stating that slower loan growth, a deterioration in asset quality and lower margins will affect profitability at the bank.  

Trading cheaply

Investors must now ask themselves whether the risks are priced-in to the share prices of Lloyds, RBS and Aldermore after the sell-off. All three companies appear to be trading cheaply: Lloyds is now trading on a P/E ratio of 7.3 times next year’s earnings with a forecast dividend yield of over 7%, while RBS and Aldermore have forecast P/E ratios of 12.5 and 4.8, respectively. Having said that, I believe it’s likely to be a bumpy ride for UK banks over the next few years, so risk-averse investors should proceed with caution. 

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Edward Sheldon owns shares in Aldermore Group. The Motley Fool UK has recommended Barclays and 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.