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Will Lloyds Banking Group plc become a Warren Buffett stock in 2017?

The government’s disposal of its last remaining shares in bailed-out Lloyds (LSE: LLOY) on 16 May represents a significant milestone in the bank’s rehabilitation since the financial crisis.

And with long-time banks bear Neil Woodford also announcing this month that he’s taken a stake in the business, the company appears to be an increasingly attractive investment proposition.

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Could legendary US investor Warren Buffett join the UK’s most celebrated fund manager in backing Lloyds?

Yardstick

The FTSE 100 bank has a market cap of over £50bn, so it’s certainly big enough to enable Buffett to buy a worthwhile stake in the business. But does it have characteristics that might appeal to his eye? Furthermore, is the current valuation attractive?

Buffett’s biggest holding in the financial sector — and his number two holding overall — is Wells Fargo. The bank has recently been involved in a scandal involving employees fraudulently opening customer accounts in order to meet cross-selling and sales targets. But the CEO has gone and Buffett is continuing to back the company. So, Lloyds’ past transgressions shouldn’t present a stumbling block for him.

As the US’s largest retail mortgage lender, Wells Fargo provides a good yardstick to measure Lloyds against.

Returns and valuation

It’s in the nature of banks that they have a low return on assets (ROA) of little more than 1% or 2% and achieve a decent return on equity (ROE) — a double-digit percentage — by financial leverage.

High leverage is great for enhancing ROE in boom times but can be disastrous in bad times. The table below shows key numbers for Wells Fargo and Lloyds going into the financial crisis.

  Wells Fargo Lloyds
ROA (%) 1.52 0.94
Financial leverage 12.2 29.1
ROE (%) 17.39 28.25

Source: Morningstar

Wells Fargo, with its relatively low leverage, was resilient through the financial crisis, while Lloyds fared rather less well — to put it mildly. However, the UK bank has since moved more towards Wells Fargo’s profile. The table below shows trailing 12-month numbers for the two companies.

  Wells Fargo Lloyds
ROA (%) 1.07 0.3
Financial leverage 11.09 16.46
ROE (%) 11.64 5.0

Source: Morningstar

Lloyds’ returns are currently still depressed by the tail-end of its legacy issues, restructuring costs and so on. An effective tax rate of over 40% isn’t helping either, but Lloyds expects this to normalise at around 27% (Wells Fargo’s is consistently around 31%).

In short, Lloyds could very soon be looking a lot like Buffett’s favourite US bank. Furthermore, as the table below shows, the valuation of the Black Horse appears relatively attractive on several measures.

  Wells Fargo Lloyds
Price/book 1.5 1.1
Dividend yield (%) 2.9 3.5
Forward P/E 12.7 11.8

Source: Morningstar

So, there could be good upside for Lloyds’ shares, if they were to re-rate closer to the valuation Wells Fargo commands.

Finally, Buffett could see Lloyds’ proposed acquisition of credit card firm MBNA as a good move, because he likes this area of the market. American Express is his fifth largest holding and he also has smaller stakes in Visa and Mastercard.

In summary, I think Lloyds’ emerging fundamentals and current valuation could have considerable appeal for him. Of course, whether he will actually invest isn’t a question I can give a definitive answer to.

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G A Chester has no position in any shares mentioned. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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