When Lloyds Banking (LLOY) announced three years ago it would start paying quarterly dividends, its reasoning was it wanted to provide ‘a more regular flow of income’ to its army of retail shareholders.

By the bank’s estimate it had around 2.4 million shareholders at the time, of which ‘the vast majority’ were small investors.

The question we have is, has this legion of shareholders received a good return on their investment and what are the risks and opportunities going forward?

AN ACQUISITION MACHINE

As the second-largest UK bank by market value behind HSBC (HSBA), and the second-oldest bank behind Barclays (BARC), Lloyds may have an image of being dull and unadventurous but it has arrived at where it is today thanks to over a century of swashbuckling acquisitions.

Founded in Birmingham in 1765, it became a listed company in 1865 when new legislation allowed banks to turn themselves into ‘joint-stock’ companies.

That change of status encouraged the bank to embark on an aggressive expansion programme, buying up more than 200 smaller rivals over the next 50 years including the London-based Barnetts, Hoares & Co, from which it inherited the famous black horse logo.

In 1918 Lloyds undertook its biggest acquisition up to that point with the takeover of Capital & Counties Bank, increasing its branch network by more than 50% and securing its place among the major high street banks.

Fast-forward to the 1990s and Lloyds took over the Cheltenham & Gloucester building society and TSB to become the biggest lender in the UK, although in 2013 it was forced to divest TSB under EU rules.

The global financial crisis saw all the UK banks struggle and in September 2008 Lloyds was ‘encouraged’ by the government to take over its ailing rival HBOS, boosting its loan and deposit base but bringing with it a mountain of bad debt.

As the crisis deepened, the government ended up buying £20.3 billion in Lloyds shares in order to keep the bank afloat, amassing a stake of 43%, which it finally disposed of in 2017.

Today the bank is the UK’s largest lender with 26 million customers, and it purely serves the retail and business market unlike its three main rivals which are also involved in investment banking.

WHAT HAVE RETURNS BEEN LIKE?

A cursory glance at a Lloyds’ share price chart would suggest investors have made no money at all over the last decade, and in fairness that isn’t far wide of the mark.

The shares have gone pretty much nowhere for 10 years, generating a return of -1.5% based on price alone.

However, when we factor in dividends shareholders have made a 40% return which until inflation took off late last year would have been slightly ahead of the CPI on an annual basis.

Moreover, both the share price return and the total return compare pretty favourably with Barclays, HSBC and NatWest (NWG), with Close Brothers (CBGT) the only bank in the FTSE All-Share to have posted a better performance.

IS IT AN ATTRACTIVE INVESTMENT TODAY?

Leaving aside for now the question of whether banks are a good investment in the present climate, if we just compare Lloyds with its main rivals it outperforms them on four of the most important measures of profitability and financial stability.

Its net interest margin, which is the difference between the average interest it pays on loans and the average rate it charges on deposits, is slightly better than its two main high-street competitors, while its cost to income ratio is significantly lower than all three of its big rivals.

In other words, for every pound of net interest income it can generate, more drops to the bottom line meaning more cash flow and more earnings out of which to pay dividends, which in turn translates into a higher return on equity.

In terms of financial stability and the potential to pay out higher dividends or buy back shares, Lloyds has the highest Core Equity Tier 1 ratio by some way which gives it flexibility.

Meanwhile, from a valuation and ordinary dividend yield perspective, while Lloyds isn’t necessarily the cheapest or the highest-yielding of the big four UK banks it compares favourably with its high street rivals Barclays and NatWest Group.

SHOULD YOU BUY UK BANKS NOW?

This is a tricky one. If central banks are going to keep interest rates higher for longer, in theory net interest margins across the sector should increase as the banks can charge more on their loans.

We have already seen how the tumult in the gilt market and the increase in yields has led banks and building societies to remove around a quarter of their mortgage products and increase interest rates on their remaining offers, which is good for profits.

However, the flip side to rates staying higher for longer is demand for mortgages is likely to fall away as homeowners try to juggle their finances in the face of rampant food and energy price rises.

Housebuilder Barratt Developments (BDEV) recently flagged a sharp slowdown in net private reservations of new homes in the third quarter, and we are likely to see a slowdown in the number of transactions in the wider housing market as falling consumer confidence collides with lower mortgage availability.

In addition, higher interest rates could sink many companies which until now have just about kept their heads above water leading to a wave of bad debts among the banks.

Admittedly the sector is much better capitalised than it was during the global financial crisis and the last wave of insolvencies, but that doesn’t mean it will necessarily get off lightly this time round.

WHAT DO THE EXPERTS SAY?

Kartik Kumar, co-manager of the Artemis Alpha Trust (ATS) and a holder of Lloyds, believes Lloyds has what it takes to ride out any recession.

‘As the UK’s largest retail bank, its size helps make Lloyds the most efficient bank in the UK and digitalisation is bringing costs down further.

‘With the UK likely already in a recession, a question remains over how safe bank investments are. Lloyds’ Core Tier 1 capital is three times its 2007 level, and two thirds of its £456 billion loan
book is mortgages which are secured loans backed by houses.

‘The mortgage book has an average loan-to-value ratio of 40%, so house prices would have to fall a long way for them to lose money, and only 0.3% of mortgages have a loan-to-value of over 90% whereas in 2010 those ratios were 56% and 14%.’

The prospects for shareholder returns are also healthy, says Kumar: ‘Lloyds has a stated objective to achieve a 10-12% return on tangible equity. Its market value is 70% of its tangible equity, which implies prospective returns of 15-18% to shareholders if it achieves that objective.’

Being over-capitalised means the bank could return more cash to shareholders adds Kumar.

‘Lloyds and other UK banks are buying back their stock to distribute excess capital in addition to dividends. That should help compound returns, given the depressed valuations at which share repurchases are being done.’

Analysts at investment bank Berenberg describe Lloyds’ second quarter results, which beat market expectations by around 20% leading it to upgrade its forecasts, as providing ‘a reassuring signal’ about future earnings.

‘Specifically, rising UK interest rates are providing a stronger-than-expected tailwind for revenues alongside benign credit quality and robust loan volumes.’

As far as the potential for a recession and an increase in bad loans are concerned, the bank says that while risks exist, including from higher unemployment, ‘our analysis suggests that most UK borrowers have ample capacity to absorb expected headwinds from high inflation and slowing growth’.

WHAT TO LOOK FOR AT THE NEXT UPDATE

Lloyds is due to release its third quarter trading statement on 27 October and investors should look out for a couple of key items.

First is the effect of higher rates on the net interest margin, which the bank believes can rise to 2.8% by the year-end compared with 2.7% in the first half.

Second is cost control, in which the bank has led the field so far in this cycle, and third is provisions for bad loans which were below market forecasts at the end of the first half.

We note US bank Wells Fargo (WFC:NYSE) commented in its third quarter results last week it saw ‘strong net interest income growth’ thanks to the positive impact of rising interest rates, while ‘both consumer and business customers remain in a strong financial condition, and we continue to see historically low delinquencies and high payment rates across our portfolios’.

However, we also note the bank’s caveat that ‘we do expect to see continued increases in delinquencies and ultimately credit losses, (although) the timing remains unclear’.

In a similar vein, JPMorgan Chase (JPM:NYSE), the biggest US bank by retail deposits and a major lender and credit card provider, said that while US consumers were still spending and businesses were healthy there were ‘significant headwinds immediately in front of us’.

In a significant change of tack, the bank ramped up its credit provisions by $1.5 billion after taking $1.1 billion of charges in the second quarter whereas a year ago it wrote back $1.5 billion of unused bad loan provisions in the third quarter.

‘While we are hoping for the best, we remain vigilant and are prepared for bad outcomes’, it said. 

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