The Motley Fool

The uncomfortable truth about Lloyds Banking Group plc

As Lloyds Banking Group (LSE: LLOY) moves towards what looks like a ‘normal’ existence after the ructions of the financial crisis, investors seem attracted to the firm for its cheap-looking valuation.

But I reckon Lloyds’ lamb-like appearance disguises an erratic wolf with sharp teeth ready to bite investors risking money on the shares.

Why Lloyds is not cheap

Today’s share price around 67p looks cheap at first glance and throws up a forward price-to-earnings (P/E) ratio just over 10 for 2018, which compares to a median forecast P/E of all stocks on the London Stock market with earnings estimates of just over 14.

Then there’s the forward dividend yield running around 6%, above the median forecast of all dividend payers of 3.2% or so. We can even look at Lloyds’ price-to-book ratio of around one and argue it indicates reasonable value for the banking group.

However, to compare its valuation figures with any kind of average for the whole market gives a false impression. Averages combine the lowest rated firms with the most highly valued outfits and all enterprises in between. Averages are nonsense because each company faces its own ‘issues’ and Lloyds has plenty of those.

A useful mind model

To me, banks are not proper trading businesses. Instead, they facilitate other businesses and people’s personal finances. In some ways, despite their best intentions and the hard work of their employees, banks are like leeches dining on the blood of other animals. If the host is in good health, the leech prospers, if not, the leech withers. I think that colourful analogy suggests a useful mind model for investors considering Lloyds.

With the ‘leech’ idea in mind, you can see why banks are among the most cyclical of stock market enterprises. If macro-economies wobble — suggesting businesses and individuals may struggle financially — the shares of out-and-out cyclical firms like Lloyds will plummet, often at the first whiff of economic trouble.

But ‘normal’ cyclicality is the least of your worries if you are invested in banks. Well-known past Fidelity fund manager Peter Lynch reckons that cyclical firms can fall too hard on a cyclical down-leg and never recover to previous glories. Anyone investing in Lloyds prior to the 2008/9 financial crisis and holding until now can verify the wisdom of that.

Why crises are normal for banks

Bank crises are nothing new. The Guardian reported during 2007 that according to Lehman Brothers (which itself filed for chapter 11 bankruptcy protection in 2008) the 18th century saw 11 banking and financial crashes. In the 19th century, another 18 occurred. There were 33 traumatic happenings in the 20th century, including the Wall Street Crash of 1929 and the Japanese financial turmoil of the 1990s. 

So far, in the 21st century, we’ve seen the sub-prime-induced financial crisis followed by the so-called Great Recession. I reckon, judging by past evidence, we’re due more catastrophic financial events before the century is over, each potential occurrence likely to decimate the total return outlook for those holding bank shares. 

With such potential for volatility in the business model, Lloyds deserves its low-looking valuation — how else can the market attempt to discount for such forward risk? City analysts don’t see much growth in earnings on the horizon for Lloyds, so the only thing going for the stock right now is fragile share-price momentum and a fat, but in my view precarious, dividend.

Investing in ‘real’ businesses

There are far safer big-cap stocks available with decent value, growth, quality and long-term momentum, such as those featured in the Motley Fool’s enduring report 5 Shares To Retire On.

These are good companies, and you can find out more about them right now. Picking the right investments can be life-changing. I’m avoiding Lloyds, but I urge you to make your own analysis of these five gems by clicking here.

Kevin Godbold 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.