Why Lloyds and the banks are so important to the UK market for 2016

The Government’s plans to sell its remaining stake in Lloyds and place a £2 billion block of stock with retail investors next spring means the bank is going to have a very high profile – and with good reason because it is one of the most important stocks in what looks to be the single most important sector in the UK market.

Chancellor of the Exchequer George Osborne’s proposed structure for the Lloyds sale is canny, as it should help to drum up interest in the FTSE 100 firm, whose operations span retail and commercial lending, credit cards and insurance and brands include Halifax, Bank of Scotland, Birmingham Midshires and Scottish Widows besides that of the black horse itself.

• Retail buyers will get to acquire stock at a 5% discount to the prevailing market price
• Any retail buyer who then holds the stock for a year will receive one free share for every ten they own, up to a capped value of £200
• Retail investors who put in for £1,000 or less will be put at the head of the queue

Add up the initial discount and the buy-ten-get-one-free offer, anyone looking to buy Lloyds shares from the Government next spring is effectively getting a 15% discount on the deal. That sort of incentive could help the placing to go well, normal market conditions permitting and let the Government sell its final slice of shares above its 73.6p in-price, getting taxpayers their money back after that initial £20-billion-plus bail-out in 2008.

Do your research

However, investors still need to ask themselves some searching questions before taking the plunge. After all, no-one would walk into any High Street shop and starting indiscriminately clearing the shelves simply because they say a sign saying “Sale: 15% off” plastered all over the windows. You would naturally make sure the goods were what you wanted or needed and that they were of suitable quality. The same must apply to any investment, including Lloyds.

• First investors must make sure the bank fits with your overall strategy, target returns, time horizon and appetite for risk. Appetite for risk means willingness and ability to suffer losses when seeking profits. Lloyds shares have traded between 72.3p and 89p over the past 12 months, a range of around 20% and one large enough to potentially offset the benefits of the 15% inducement should something go wrong. Anyone wishing to make the most of the deal structure would also need to hold the stock for at least a year, tying up their cash.

Source: Thomson Reuters Datastream

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

• Second, investors must then weigh the investment case. Lloyds operates in a fairly mature market, that is very competitive and pretty tightly regulated, especially when it comes to how much capital the bank has to keep on its balance sheet to try and protect itself from any future downturns. All of these features mean earnings growth is likely to be modest, unless the bank takes more risk and lowers its lending standards or makes an acquisition – and not everyone would welcome either of those. Further cost-cutting is possible but again that represents relatively low quality earnings and will only go so far. That means the bulk of future returns may have to come from dividends and the yield on the stock. The good news here is Lloyds reinitiated dividend payments in 2014 and has already made a 0.75p interim distribution in 2015. The analyst consensus is for a 3.87p payment in 2016, enough for a 5% yield on the current share price of 76.2p. In a low-interest-rate world this will catch the eye of income seekers, who must then do their research to ensure these forecasts are attainable and sustainable.

Source: Company accounts, analysts consensus forecasts, Digital Look

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Big Five banks

Higher dividend payments and a juicy potential yield will probably form the key planks of the investment case for Lloyds, whose influence over the FTSE 100 should not be underestimated.

Our research shows that the analyst consensus for 2016 has the FTSE 100 growing its earnings by 10%. That is a £15.9 billion increase in actual cash terms and one fifth of that, or £3.2 billion, is expected to come from the Big Five banks – Barclays, HSBC, Lloyds, RBS and Standard Chartered.

Moreover, three banks – Lloyds, HSBC and Barclays – are expected to generate between them some 42% of the FTSE 100’s forecast aggregate dividend growth in 2016.

Source: Company accounts, analysts consensus forecasts, Digital Look

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

As such it is hard to underplay the importance of the Bank sector for 2016 and any investor who is bearish may have to move carefully if they are considering taking exposure to the FTSE 100. Note that the analyst consensus expects the aggregate earnings for the Big Five in 2016 will finally exceed the peak seen in 2007, just before the Great Financial Crisis.

What percentage of earnings back then came from activities which have subsequently led to fines and customer compensation is hard to define but it seems a fair assumption that the banks are going to have to work hard to drive earnings a lot higher from here, at least in the current environment of sluggish growth.

Source: Company accounts, analysts consensus forecasts, Digital Look

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

The substantial swings in aggregate banking sector earnings over the last decade may persuade some the potential returns on offer represent inadequate compensation, when set against the risks of recession, regulatory intervention and competition from ‘challengers.

Russ Mould

AJ Bell Investment Director