Some of the main beneficiaries of this economic revival have been the so-called “battered banks”. They have been one of the principle drivers of the rally in UK equities, with many of the banks coming back from extremely low valuations.
One such bank has been Lloyds. Readers will no-doubt remember that during the chaos following the financial crash in 2008 the government took a 40 per cent stake in the floundering bank.
Now however, with the government offering 6 per cent of Lloyds back to the market and with its remaining 33 per cent stake expected to be sold in the near future, the question is whether the bank is still a buying opportunity.
If you take a short term snapshot, shares in Lloyds have certainly rallied recently in recent months, reaching 74p at the time of writing.
According to FE Analytics, investors in the stock would have seen returns of 92.8 per cent if they had bought a year ago. As a point of comparison, the FTSE All Share has returned 20.22 per cent over that time.
Performance of stock versus index over 1yr
Source: FE Analytics
However, if you had bought Lloyd shares three, five or 10 years ago they would have lost money.
What I realised from a recent trip back home outside of London was that there was a lot of private investor interest in Lloyds, with many of the people I spoke to having bought shares in the bank over the last 12 months.
I asked Steve Davies (pictured), who runs the Jupiter Undervalued Assets and Jupiter UK Growth funds, to give me the profesional's view on the bank’s outlook and my friends' decision to invest.
The manager has been a big fan of Lloyds in the past, and the stock is his largest holding in both of his funds, making up 9.6 per cent of his 114m Undervalued Assets fund and 9.03 per cent of his £892m UK Growth fund. Combined, Davies and, his co-manager FE Alpha Manager Ian McVeigh, own around £78m in Lloyds shares.
Why did you buy Lloyds in the first place?
Davies is an out and out value manager and says he bought into Lloyds originally in 2009 and again when he launched his Undervalued Assets fund in February last year.
“The thesis behind it hasn’t really changed, it has just taking taken a little longer to come through than we first imagined,” he explained.
“We felt that once they got rid of all the rubbish then they could pay out 8 or 9p on earnings and would turn into a very boring bank that won’t be growing very fast. If they could pay 8p on earnings – and with the chief exec saying they could have a 70 per cent pay-out ratio – then you could be looking at a dividend or around 5 or 6p per share.”
“Our target price for shares in Lloyds is £1 or just a little over that because that is around the level that plenty of sensible banks are trading on.”
“It didn’t seem too much to ask for, but at the time we had bought shares at around 25p. However, if you think you have a decent opportunity you have to be prepared to stick a fair bit of money behind it,” he added.
What is the situation now?
The manager says that there have been three hurdles that Lloyds has had to get over before the market really became bullish on the stock.
“The question from there was what needs to happen to get from A to B?” Davies said.
“At the time, we didn’t think that the UK economy was about to tank, though fortunately there were a lot of people who felt the UK was on its knees. However, we realised early last summer that things weren’t as bad as most were making out.”
“We could see employment was going up and that funding for lending was increasing the availability of credit.”
“The second point was what were the regulators going to demand of Lloyds in terms of capital requirements. Twelve months ago they had been pragmatic but then went the other way and said Lloyds needed more.”
“Now it is pretty clear that the regulators are happy with their capital ratio, but the management team will probably want to create a buffer just in case. Nevertheless, we are pretty much there and now there is the debate whether Lloyds will be able to pay a dividend on this year’s earnings.”
“It would be pretty low, but it would be a good signal to the market and they should be able to,” he added.
However, Davies says that one of the reasons why shares in Lloyds haven’t been able to break through £1 has been because of payment protection insurance claims [PPI], which have hindered the banks progress.
“The third bit – and one of the reasons the process has taken a little longer than we first thought – was that they were having to pay off PPI claims,” he said.
“We are not at the end of PPI, but the amount of claims are falling away and after a period of intense publicity, we feel Lloyds has enough tucked away to deal with any more. However, to be frank we did get the magnitude of PPI wrong,” he added.
The manager says the long term looks good for Lloyds as banks are one of the few equities that do well in a rising interest rate environment. He also says that if the housing market continues to strengthen then that is also good news for the share price.
“The other point to make is that over the last five years Lloyds has shrunk its loan book,” Davies explained. “If they are able to start growing their loan book in terms of credit cards and personal loans then they will be to gain more interest on their PNL [income statement],” he added.
What is the longer term outlook for Lloyds like?
Davies says that when you evaluate Lloyds long term potential, the main question is when and how the government will sell down its large stake in the business.
“The when will really be determined by the how,” he said.
“Do they try and get retail investors involved? There are plenty of merits in doing that. Do they do a Royal Mail and just have it that people apply for shares or do they just have a taxpayer give away? Whether that would encourage more equity investment in the UK, who knows?”
“However, they were able to shift 3.3bn worth of shares overnight so that isn’t a bad effort. People knew it was coming so it didn’t really come as a surprise though,” he added.
Davies says that he and McVeigh would probably look to sell down their exposure to Lloyds when the stock hits their target prices, but holding onto the company for longer could work in the favour of other investors.
“I think that the incremental demand will come from equity income funds who haven’t been able to invest in UK banks because the sector just hasn’t been paying a dividend,” he added.
Davies has run funds in the IMA universe since April 2009. According to FE Analytics, over that time he has returned 148.1 per cent to his investors beating his peer group composite which has returned 108.24 per cent.
