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Is now (finally) the right time to buy Lloyds Banking Group plc?

Is Lloyds Banking Group (LSE: LLOY) a stunning contrarian buy, or a risky play on the UK’s costly housing market? The market can’t seem to decide and the shares have fallen by 20% so far in 2016, despite a fairly solid set of first-half results.

In this article I’ll take a look at the pros and cons of an investment in Lloyds, and give my view on whether the bank’s shares are a buy.

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Good progress

Although Lloyds’ underlying profit fell by 5% to £4.2bn during the first half, the bank’s exceptional costs fell by 46% to £1,707m during the period. As a result, the bank’s reported net profit — after all exceptional costs — doubled to £1.9bn.

It’s important to remember that while we’re now used to banks presenting us with good underlying results but poor statutory figures, this isn’t normal. Such a huge gap between underlying and reported profits is often a sign of a business that has problems.

Lloyds appears to be starting to close the gap between reported and underlying profits. This is reflected in the bank’s return on equity. Lloyds reported a statutory return on equity of 8.3% and an underlying figure of 14% for the first half of 2016. These figures are much closer than the 3.7% and 16.2% reported for the first half of last year.

If Lloyds’s exceptional costs continue to fall, then I estimate that the bank should be able to achieve a ‘clean’ return on equity of more than 10% over the next year or so. That would put Lloyds well ahead of most of its major peers.

Tough headwinds

One of the biggest problems facing UK banks is that ultra-low interest rates are making it hard to make decent profits. While public sympathy for bankers’ problems may be low, as investors we need to consider this.

The EU referendum was followed by the Bank of England cutting the Bank Rate to a new record low of 0.25%. There are concerns that the Brexit vote may have been a turning point for the housing market and even for the UK economy.

This is potentially a big issue for Lloyds, as the bank has £297bn of secured retail loans on its books. Most of these are mortgages, which account for about 65% of Lloyds’ total loan book.

Will the housing market crash?

The summer holidays are traditionally a quiet time for house sales. We’ve yet to see any meaningful post-referendum sales figures. However, in its latest House Price Index report, property website Rightmove said that “the outcome of the second half of 2016 hangs on the strength of the traditional autumn market rebound.”

Any evidence of a slowdown this autumn could result in a rapid sell-off of housebuilding and mortgage-lending stocks.

Attractive valuation, but is Lloyds a buy?

Consensus forecasts suggest Lloyds’ earnings will fall by 13% in 2017, to 6.4p per share. This puts the stock on a forecast P/E of 9. A forecast dividend 3.66p per share gives a prospective yield of 6.3%.

I think Lloyds could be a reasonable dividend buy at current levels, but I don’t think it’s a screaming bargain. I suspect that the market will remain tough and that dividend growth could be slower than expected.

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

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