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Holly LaFon
Holly LaFon
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David Herro Comments on Lloyds

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January 09, 2019 | About:

Lloyds (NYSE:LYG) is the Fund’s second-largest international holding. The company’s share price declined 25% in 2018, resulting in a negative return contribution of 112 basis points. Despite the poor performance of the stock price, the company’s earnings and capital generation were actually in-line with expectations and its underlying fundamentals remain strong and are expected to improve further in 2019. Lloyds is the largest retail bank in the U.K., commanding a market share of nearly 25% of the consolidated U.K. banking market in which the top four participants control nearly 80% of the market, combined. Additionally, the company’s management team has improved operational efficiency, reduced exposure to more economically sensitive asset classes and built excess capital. For instance, Lloyds’ commercial real estate exposure has fallen to only 3.6% of group loans and its underwriting remains quite conservative, as evidenced by the company’s residential mortgage book, which boasts an average loan to value of 43.5%. Meanwhile, Lloyds has maintained an excess capital position of approximately two billion pounds, despite returning GBP 3.2 billion to investors during 2018. We expect the company to generate an underlying return on tangible capital in the mid-teens for 2018, despite its excess capital position and we believe that additional cost efficiencies could boost underlying returns even further. We estimate Lloyds will report a return on tangible equity of roughly 13% for 2018. However, this metric is being restrained by provisions for the mis-selling of legacy payment protection insurance products. This liability will sunset in August of 2019, and as a result, we believe the company’s reported profitability should improve in both 2019 and 2020.

We recognize that uncertainties surrounding Brexit could create a softer economic environment. To analyze this risk, we have factored in various adverse scenarios to gauge the potential effects on Lloyds’ earnings and its capital, and as a result, we believe that the company will be able to navigate any short-term headwinds because of its strong earnings generation, conservative underwriting and large excess capital position. We estimate conservatively that Lloyds is trading at 5-6x reported 2020 earnings and approximately 0.8x its 2020 tangible book value. This is a highly discounted valuation for a best-in-class financial institution.

From David Herro (Trades, Portfolio)'s Oakmark Global Fund fourth-quarter 2018 shareholder letter.

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Holly LaFon
I'm a financial journalist with a master of science in journalism from Medill at Northwestern University.

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