Margin of safety makes Lloyds attractive

Lloyds (LON:LLOY) has a valuation which I think is exceptionally cheap. I feel this will be important during 2017, since there are clear risks facing investors. For example, Brexit talks are about to commence and according to the President of the EU Commission, Jean-Claude Juncker, the two-year period will see the EU adopt a tough negotiating stance. Therefore, business, consumer and investor confidence may ebb away.

Similarly, Donald Trump’s economic and social policies could create an environment of uncertainty. This may be compounded by an increasingly hawkish Federal Reserve and a potentially higher rate of inflation. Therefore, I believe buying shares which have low valuations given their future outlook, financial standing and strategy makes more sense than ever.

The results reported this week by Lloyds showed it is making progress. It is relatively efficient, has a sound balance sheet and could make further improvements in both of these areas. Additionally, its shares offer income potential which I believe the market has not yet fully woken up to, while it also has the crucial margin of safety.

Risky outlook

While seeking to buy shares at a discount to their intrinsic value is sound advice in any market conditions, it could prove to be even more important in 2017. The future for the UK economy is decidedly unclear, and could be affected greatly by Brexit negotiations. They are due to start within five weeks and will be tough, uncompromising and highly uncertain, in my view.

Both sides have already made it clear that no deal is better than a bad deal. In my opinion, a ‘no deal’ scenario is relatively likely since two years may be insufficient to negotiate the terms of the ‘divorce’. Given the uncertainty which has already been present before negotiations have even started, this would be unlikely to inspire confidence in UK plc.


Investors also face a threat from the Donald Trump Presidency. His economic and social policies have thus far caused share prices to rise, but they could easily cause uncertainty and even fear in the remainder of 2017. Much of the rally in shares has been predicated on an assumption his economic policies will cause the economic growth rate to rise.

However, their result could simply be a higher rate of inflation and a lack of a substantial increase in real-terms growth. Any potential increase in economic growth resulting from Trump’s accommodative fiscal policy may be choked off by a more hawkish Federal Reserve. Therefore, investors who have priced in a faster-rising GDP level from Trumponomics may end up disappointed.

Margin of safety

In such an era, a cautious stance on share purchases may be required. In my view, a larger margin of safety must be sought before buying any stock. Lloyds currently has a P/E of 10.3, which I believe significantly undervalues the business.

There are two main reasons for this. First, Lloyds has become a highly efficient business following a sustained period of cost reductions. Although job losses and redundancies have not made for good headlines, they have improved the bank’s cost-to-income ratio to 48.7% in 2016. There is further potential for a lower ratio, with the company stating in its results a figure of 45% is being targeted by 2019.

Lloyds has become a highly efficient business following a sustained period of cost reductions.

Second, I think its balance sheet is in good shape. Its core equity tier 1 (CET1) ratio moved 80bps higher in 2016, and Lloyds expects to generate up to 200bps of CET1 capital per annum. This should help it to survive what could be a troubled period for the UK economy.

Higher inflation may prompt lower GDP growth as consumers struggle to maintain present day spending levels. Consumer confidence levels have been negative for around a year and they are expected to fall from the present level of -5 to as low as -8 by the end of the year. The ability of companies and individuals to service and repay loans may decline, sending UK GDP growth lower. Lloyds’s relatively high capital ratios could therefore be a differentiator between itself and sector rivals.

Possible catalysts

In my opinion, a margin of safety in itself is not enough to warrant the purchase of any share. Lloyds has the potential to register relatively high capital returns in my view, partly because of its income prospects. At a time when inflation is already 1.8% and could reach 4% this year, Lloyds’s payout ratio of 44% and progressive dividend policy may ignite investor interest. Its yield may not be the highest in the FTSE 100 at 4.3%, but it is top quartile and could even become top decile if its 13% rise in ordinary dividends continues.


The acquisition of the MBNA prime UK credit card business also opens up an avenue for further growth within the consumer finance segment. This could improve Lloyds’s overall returns in my view over the long run. Similarly, the sale of the government’s <5% stake may also mark the start of a new era for the bank and mean the market views it as less risky. It may also provide the company with greater scope to become more competitive on pricing and explore more aggressive growth options.

Outlook

Share prices face an uncertain outlook in 2017. The effect of Brexit negotiations and Trump’s economic and social policies on market sentiment could be significant. A UK/EU deal may prove elusive, with tough negotiations likely to reduce confidence in UK plc, in my view. Trumponomics may also fail to deliver on the scale which is currently priced in to valuations. Increasing inflation could lead to a more hawkish Fed which dampens GDP growth.

Therefore, I believe buying shares with greater margins of safety could be more important than ever. Lloyds has a P/E of just over 10 and yet has become a relatively efficient and financially sound entity. This is demonstrated by its improving CET1 ratio and low cost-to-income ratio. More improvements could lie ahead for both ratios, while the sale of the government’s shares and the company’s income potential may act as further catalysts. Therefore, in my opinion Lloyds is a sound long-term investment.