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One ‘hidden’ reason I think Lloyds Banking Group shares could disappoint

There’s no shortage of bullish opinions about Lloyds Banking Group (LSE: LLOY) and one of the main arguments is that the valuation looks cheap. The dividend yield is high and, to many commentators, the bank looks like it’s poised for recovery after many troubled years since the financial crisis.

However, Foolish writer Martin Bodenham punched out an article recently that added to my bearishness about Lloyds and which made me think about a ‘hidden’ reason for avoiding the shares. His article bore the headline ‘Why dividend yields don’t matter to me’ and he made a good argument for targeting total investor returns over dividend income.

Two steps forward, two back

Let’s face it, if you look at Lloyds’ history over the past few years total returns have taken a bashing from that wiggly share price. It looks like a strong case of two steps forward with dividend income only to have your gains wiped out later by two steps back with the share price.

But when searching for potential investments, Martin considers the most important indicator to be Return on Capital (ROC) and not the dividend yield at all. His reasoning is compelling. When talking about any company, he said: “There is no better measure to demonstrate the effectiveness of its leadership team in exploiting the business’s competitive position in the market.”

Indeed, a high ROC figure can lead to strong performance from a share price even though a firm’s dividend yield may be low. Instead of paying cash back to shareholders, many firms with a high ROC plough money back into their businesses to make the most of their opportunities for growth.

One thing that screams out to me about Lloyds is its poor showing on all the traditional quality indicators. One popular share screening website has the ROC running at just 0.75% and the Return on Equity at 8%. The operating margin looks better at around 21%, but the bank has had to build that up from almost zero in 2013, which is another sign of the fragility of the underlying business, in my view.

Commodity-style, cyclical outfits

Banks tend to be highly financially geared. They have to be to turn any kind of worthwhile profit. But they are also cyclical and lacking in any meaningful competitive advantages over their peers. Banks such as Lloyds are commodity-style outfits and profitable operations depend on a number of economic variables. If we see a half-decent general economic slump at some point, my guess is that Lloyds profits, the dividend, and the shares will all plunge.

And that’s what I reckon the stock market as a whole is worried about with Lloyds. After a long period of strong profits from the firm, I reckon the market is pegging and shrinking the valuation in anticipation of the next downturn.

To me, the share is good for trading short term to ride the cyclical ups and downs in the share price. However, I wouldn’t try to use Lloyds as a long-term dividend-led investment and I’m not expecting a prolonged surge in the share price because of the company ‘exploiting its competitive position in the market’.

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Kevin Godbold has no position in any share mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.