I’ve bought shares in Lloyds (LSE:LLOY) at 41.69p (Market capitalisation £29.4bn). The group, which also owns Halifax, Scottish Widows and Bank of Scotland, seems on a low price relative to proven earnings over the last ten years, and it has a strong balance sheet providing plenty of downside protection.
While its shares have risen from last autumn’s lows of 24p on relief at having escaped the prospect of mass loan defaults they have not yet incorporated a conservatively estimated earnings power number based on analyses of,
(a) the historical record, and
(b) an allowance for the positive impact on earnings power of the economic recovery on customer defaults, on net interest margins and on expansion of lending and other activity such as insurance.
Nor does the current share price fully take into account the potential for significant rises in dividends and/or share buybacks. This greatly increased flow of cash to shareholders seems likely to occur given the overly cautious balance sheet.
The Group has a 16.2% risk-weighted reserve of shareholders’ equity backing up loans, etc. This high level of equity reserves becomes increasingly anomalous (too timid and inefficient) as profits grow in the recovery and are stacked up on the balance sheet.
For comparison, Lloyds’ risk-weighted reserve back in 2007 was 8.1%, the same as in 2012. Regulators today like to see a larger pot of money coming from shareholders to back up lending than they did a decade or so ago and so we should expect an elevated level. However, even the ultra-cautious regulators are only demanding 11% for Lloyds, not 16.2%.
The more stringent metric, the leverage ratio, which basically compares the amount of shareholder equity capital as a percentage of total exposure via loans to customers, etc. (i.e. raw bank assets without any risk-weighting), has been built up to 5.8% in 2020 compared with about 4% in 2012. Currently the banking regulators require a mere 3.25%.
The risk-weighted equity reserve (called CET1) and the leverage ratios both indicate that Lloyds,
(a) has not lent out so much that it is vulnerable to financial distress should a normal recession occur with its attendant customer defaults, and
(b) has plenty of room left to expand its balance sheet, i.e., lend a lot more, before it comes close to turning a very strong balance sheet into one that poses a worrying risk for holders of its shares.
A history of earnings
Before considering the earnings numbers over the last ten years we first need to think about the inclusion of deductions in each of those years for Payment Protection Insurance, PPI.
The selling of PPI was stopped in 2006, but the compensatory pay outs from the banks did not really get going until a few years later. In the period 2011-2020 Lloyds made payments totalling a massive £22bn. The accounting treatment in those years was to deduct provisions for PPI before arriving at “statutory profit before tax”.
So here is the question: in order to understand underlying earnings achieved in each of the last ten years should we add back the PPI provisions?
After all, none of sales of PPI occurred in the last decade and nor are such pay outs going to be repeated in future years, which is where our focus really lies.
If we are trying to estimate future earnings power then I suggest we add back 80% of PPI provisions each year (a 20% deduction is made because tax was lowered due to the PPI expense – it’s a rough estimated rate, tax was actually at a wide variety of rates over the last decade).
£bn 2020 2019 2018 2017 2016
Net interest income (interest income minus interest paid out) 10.8 12.4 12.7 12.3 11.4
Other income 3.6 4.7 5.1 5.2 5.2
Net income 14.4 17.1 1………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Prof. Glen Arnold
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