An unfortunate reality of investing is that cheap stocks can always get cheaper. We saw this last week with Lloyds Banking Group (LSE: LLOY). The FTSE 100 bank looked cheap already, but Thursday’s half-year results caused Lloyds’ share price to fall by a further 8%.
The problem is that investors have taken fright at the bank’s gloomy outlook for the UK economy. I’m not surprised. The bank increased its bad debt provisions by £3.8bn during the second half and believes unemployment could hit 9% by the end of this year.
The safest option now is probably to steer clear of Lloyds shares. But I think it’s also true that the current panic could turn out to be a buying opportunity.
House price fears weigh on Lloyds share price
As the UK’s biggest mortgage lender, unemployment and house prices are high on the radar for Lloyds’ management. Rising unemployment is likely to lead to a rise in missed mortgage payments and falling house prices.
Although Lloyds obviously has a large amount of historical data to draw on when modelling possible losses, forecasts are always risky. The bank’s own modelling covers several different scenarios.
Lloyds’ central forecast is that unemployment will average 7.2% in 2020, while house prices will fall by 6%. In 2021, Lloyds expects unemployment to stay at about 7%, but thinks house prices will level out.
However, there’s a wide range of uncertainty in these numbers. For example, Lloyds’ best-case scenario for 2021 shows houses prices rising by 5%, but its worst-case scenario is for a fall of 11.5%
Things might not be this bad
Accounting rules for banks have changed since the 2008 financial crisis. One big difference now is that banks have to predict how much bad debt they expect to see, rather than reporting it after it’s happened.
These rules (known as IFRS 9) mean that the bank’s eye-catching £3.8bn impairment charge for the first half of this year is just an estimate. Although it was still enough to send Lloyds’ share price to a new nine-year low, the bank hasn’t actually seen this much bad debt yet. And it might not.
Looking back at the financial crisis, mortgage losses weren’t as bad as first feared. Low interest rates and rising house prices meant that most mortgages were made good in the end.
Lloyds share price: my verdict
I think management is wise to be cautious when faced with such an uncertain outlook. If things turn out better than expected, no one will complain.
Indeed, if the bank’s eventual losses are smaller than expected, management will be able to reverse the loss provisions made this year and add them to future profits. I know it sounds crazy, but that’s how the accounting rules work.
On the other hand, if this week’s forecasts have to be cut in the future, management could face a lot of criticism.
As I write, Lloyds share price is 26p. That’s a 50% discount to its tangible net asset value of 51.6p per share. On a long-term view, I think this is probably very cheap. Over time, I’m confident the bank will return to its previous role as a popular high yield dividend stock.
However, the next couple of years could be very difficult. I’d suggest locking the shares away and checking back in five years’ time!
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Roland Head has no position in any of the 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.