U.K. Prime Minister Liz Truss was forced out by the bond market vigilantes earlier this week. Since we do not yet know who the country's next leader will be, owning Lloyds Banking Group PLC (LSE:LLOY, Financial) (LYG, Financial) could be considered a bit of a contrarian bet.
Fundamentally, however, the retail bank is in good shape and well placed to take advantage of the U.K.’s macro situation. Lloyds’ balance sheet is now a big positive as interest rates rise since its funding is heavily weighted to long-term cash deposits, matched nicely against similarly long-duration assets.
It is no wonder this stock is one of guru David Herro (Trades, Portfolio)’s top financial holdings in his Oakmark International Fund. I believe Lloyds has been overlooked by the market, but it is a good carry trade as the stock should track the hawkish interest rate environment. Higher interest rates will bring margin and income growth to the U.K.’s largest retail bank.
In dollar terms for Lloyds’ American depositary receipt, the stock is down nearly 29% year to date, in large part due to the weakness of the pound. Similarly, the London-listed shares are down 12.5% as fears about the U.K. economy and general political instability have deterred investors. Additionally, high volatility in U.K. government bonds, locally called gilts, and higher gilt yields have frightened some investors. As U.K. banks are big owners of gilts, jumps in yields or lower bond prices would mean core Tier 1 capital levels would be down. With the respected Jeremy Hunt now in place as the U.K.'s Chancellor of the Exchequer, or finance minister, things appear to have calmed down in the government's bond markets, helped by the Bank of England's actions to ensure order.
More fundamentally for Lloyds, and something the bank can control, is that its sheer size is a competitive advantage. Rivals such as Monzo have failed to get traction and upset the big five U.K. banks – Barclays PLC (BCS, Financial), Lloyds, HSBC Holdings PLC (HSBC, Financial), Banco Santander SA (SAN, Financial) and NatWest Group PLC (NWG, Financial). Deposits are sticky, which gives a funding advantage to these big banks. U.K. consumers have also been saving more thanks to the economic uncertainty and, as a result, this money ends up as higher deposits at the banks.
We can see this from the Bank of England’s most recent Money & Credit report. Households have increased their cash levels to the highest rate since 2010 and have been paying down debt. Deposits saw net flows of 4.3 billion pounds ($4.8 billion) in July compared with 2.6 billion pounds in June. In addition, time deposits increased by 2.8 billion pounds to the highest levels since November 2010. Savers are depositing more now that short-term interest rates are coming off zero. This demonstrates that banks like Lloyds are much less reliant on capital markets now.
Net interest margins
Lloyds’ position as the U.K.’s largest mortgage lender also gives it economies of scale. If mortgage demand drops, the bank is confident it can lower mortgage rates to recapture market share. On the other hand, it can manage risk if it becomes worried about credit risk by increasing its spreads for new lending.
The bank is set to win market share against smaller and specialist lenders as these groups are more dependent on capital markets for funding, and its cost of capital is rising faster than those coming from sticky deposits that Lloyds enjoys. Lloyds' market share of the mortgage market in the U.K. has been consistently steady around 18%, with NatWest having the second-largest share at about 12%
A Berenberg research report I was recently sent noted that for every one percentage point increase in interest rates, U.K. bank revenues can grow by four to eight percentage points, meaning probably an 8% to 20% increase in pre-tax profits.
Lloyds has focused on mortgages, so it has a relatively small commercial banking business and no investment bank to speak of. Lending outside of mortgages has been quiet and the bank has focused on building up capital reserves, so higher interest rates have not really hit non-mortgage loan growth as it was already such a small revenue line. The bank’s main emphasis on controlling costs during the pandemic has given it a very strong balance sheet now. It also has a high Piotroski F-Score of 8.
The bank reported a 95% loan-to-deposit ratio at June 30, which is a conservative number. As a rule of thumb, less than 100% is good, while more than 100% is bad as it indicates loans are not funded by volatile capital markets.
Right now, the U.K. labor market is quite tight and wage growth is strong. The country’s ongoing deficit in housing supply means Lloyds’ mortgage-dominated asset base should be resilient even in a recession. This makes Lloyds less risk than Barclays, which has a much larger credit card business, where impairments might build.
Valuation and conclusion
Lloyds trades on a forward price-earnings ratio of 6.4. It has a price-to-tangible book value of just 0.7 and a dividend yield of 5.1%, which is close to a one year high. All these metrics are better than its industry peers, according to GuruFocus data.
With the pound Sterling potentially stabilizing at current levels, Lloyds looks quite cheap.
