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Here’s why I’m not buying Lloyds shares

Image: Lloyds

Lloyds (LSE: LLOY) shares have been on a strong run lately. Since September, the stock has doubled in price to 48p at the time of writing. And they’re up from around 33p a year ago. Despite this jump, the shares are still trading below their pre-pandemic levels (which reached 64p in December 2019). This has caused some investors to wonder whether this is a good time to jump in.

The positives

Lloyds shares are attracting investors for a number of reasons. Firstly, Lloyds is the UK’s largest retail and commercial financial services provider with over 25 million customers. As such, it is at the centre of the country’s economic recovery. As vaccines are rolled out and the economy emerges from the pandemic, confidence and economic activity should pick up. This should have a positive effect for the company, which should benefit from increased borrowing. The bank’s performance in Q1 2020 demonstrated early signs of this, achieving a £6bn growth in open book mortgage lending.

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Secondly, the company operates a ‘low-risk’ business model. This means it focuses on its core businesses of retail and commercial banking, general insurance and long-term savings. These areas are less volatile than other financial services, such as investment banking. It also tries to make sure its loan portfolio is of the highest quality with 70% of its commercial banking loans being investment grade. This means the bank should be less exposed to the risk of widespread defaults than its competitors.

And the company has an impressive capital adequacy ratio, a metric that measures the ability of financial companies to absorb losses. One of the most popular capital adequacy ratios is CET1. In Q1, Lloyds’ CET1 ratio stood at 16.7%. This is well above the bank’s target of 13.5% and the required ratio of around 11% set by the bank’s regulators.

The negatives

So after all the positives I’ve just mentioned, why am I not buying Lloyds shares? The answer is because I tend to avoid bank shares altogether. This is for two reasons.

Banks are incredibly cyclical businesses. This means that their performances are heavily linked to the performance of wider economy. While it might be possible to know what the economy is going to do in the short term, forecasting long-term economic trends is far harder. Tougher still is forecasting the long-term trends regarding other important macroeconomic factors, such as interest rates. This is crucial in determining the long-term success of a bank such as Lloyds, yet it’s near impossible to do with any great accuracy (for me at least).

Secondly, banks are complicated businesses with relatively opaque balance sheets. In order to fully assess the financial position of a bank like Lloyds, I’d need to understand the quality and kind of loans it makes. The fact that over 70% of Lloyds’ commercial banking loans are investment grade is encouraging, but it’s no guarantee that these loans will be paid back (think back to the 2008 financial crisis). In the modern economy, there are also countless types of loan a bank can make, all with different implications. Due to these factors, I don’t feel confident I can fully assess Lloyds’ financial position and overall risk level. I prefer to stick with what I know. As such, I’m unwilling to invest in the company.

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Ollie Henry 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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