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Interested in Lloyds shares? Here’s what I’m buying instead

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Buying Lloyds Banking Group (LSE: LLOY) shares was once seen as a safe, conservative investment that would provide reliable dividends. I’m not sure that’s true anymore. Since the financial crisis, Lloyds — like other high street banks — has failed to deliver for shareholders.

Lloyds share price is 60% lower than it was five years ago and 50% lower than it was at the start of 2020. Although I’m confident the bank’s balance sheet is far stronger than it was in 2010, I’m less convinced about the outlook for shareholders.

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Today, I want to take a fresh look at Lloyds. I’ll also reveal the name of the FTSE 250 banking group I’ve been buying instead this year.

What’s wrong with Lloyds shares?

Even before the coronavirus pandemic disrupted the UK economy, there were signs Lloyds was struggling to deliver much growth. The group’s 2019 results showed a 7% fall in underlying profits and revealed a 38% increase in bad debt charges. Lloyds’ return on tangible equity, a key measure of profitability, fell from 11.7% to 7.8%.

Of course, the situation has been made far worse by the impact of the pandemic. Lloyds’ bad debt provisions rose to £3,818m during the first half of this year, compared to £579m for the same period last year. Even excluding this factor, the bank’s trading profits fell by 26% during the first half.

Consensus forecasts suggest Lloyds will manage a modest profit this year, before returning to more normal performance in 2021. There’s some hope of a dividend next year, but I expect low interest rates and an increase in bad debts to keep the bank’s profitability under pressure.

I’m not sure when this situation will start to improve. As a result, I’ve decided to avoid Lloyds shares and focus on specialist lenders.

I’ve been buying this FTSE 250 dividend stock

The bank I’ve been buying for my portfolio this year is FTSE 250 firm Close Brothers Group (LSE: CBG). This merchant bank isn’t some brash newcomer – Close Brothers has been in business since 1878.

What makes this £1.7bn business different to the big FTSE 100 high street banks? One difference is that Close Brothers doesn’t have a costly branch network. Nor does it provide current account services or low-margin mainstream mortgage lending.

Instead, Close offers commercial lending, car loans, wealth management and stockbroking services. Although these are all areas that could be hit in a recession, the bank’s long history of profitability gives me confidence in management.

For example, during the 2008 financial crisis, Close didn’t cut its dividend. By contrast, Lloyds shares didn’t pay dividends between 2009 and 2014.

Close Brothers’ chosen lines of business all enjoy attractive profit margins. The group’s banking net interest margin — effectively its profit on lending — was 7.5% last year. The latest figure for Lloyds is 2.6%.

In 2018/19, Close Brothers generated a return on tangible equity of 17.9%. Although this figure has fallen to 9.4% this year, I expect the full-year figure for Lloyds to be much lower than this.

Close Brothers’ shares trade at a valuation premium to Lloyds shares. But the smaller bank has already restarted dividend payments and the stock offers a forecast yield of 4.6% for 2021. I think it’s a much safer investment and have been buying Close Brothers shares for my portfolio.

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Roland Head owns shares of Close Brothers Group. 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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