Why Lloyds Banking Group PLC Stock Surged 13% in May

What: The shares of Lloyds (LSE: LLOY) (NYSE: LYG.US) — the best-performing bank in recent weeks — rose 13% last month, closing at their multi-year highs on 15 May. 

So what: In May, several elements contributed to its outstanding performance, which caught the bears by surprise. There were two defining moments during the first half the month.

First, Lloyds reported strong first-quarter results, which showed rising returns on the back of higher profitability and earnings. Meanwhile, core capital ratios looked solid. In a frothy market, all these elements determined a 7% surge in its stock price on 1 May. 

Then the General Election boosted confidence in the whole financial sector — Lloyds gained more than 5% following the win of the Conservative Party one week later. Among other things, investors seemed even more eager to bet on fast-rising dividends at the time; and, of course, on a more accommodative policy concerning a not-so-small matter known as bank levy — essentially, taxes that lenders have to pay to be allowed to lend.

It could easily be argued that in a month during which the FTSE 100 was flat, while risk-off trades prevailed, bad news at other banks (HSBC) that are in restructuring mode (Royal Bank of Scotland, Standard Chartered), or whose inflated valuations do not seem to be sustainable (Barclays), helped Lloyds deliver a stunning performance to its shareholders. 

Now what: The stock is virtually unchanged since 8 May, and that’s easy to explain. 

There’s too much paper on the stock market (too many shares can be bought and sold), and the UK government still holds a circa 20% stake in the bank, all of which may prevent Lloyds stock from flying high, although savvy investors should carefully monitor quarterly results to determine whether Lloyds will continue to fare better than others. 

Based on fundamentals, core financial metrics as well as trading multiples, it’s hard to see how Lloyds could soar any higher than 90p/95p a share, or 0.65p/5.65p above its 52-week and multi-year high of 89.35p as of 3 June.

It currently trades at 86.7p. 

According to market consensus estimates from Thomson Reuters, Lloyds would be fully valued at 89p a share, although some bullish analysts have pencilled in a price target of 103p a share. For their part, those in the bear camp suggest a valuation of 55p — I’d bet on a fair value of 65p a share, some 14p below the mid-point. 

Lloyds is not a penny stock, but if the bank is ever to reach a valuation north of 100p, the government will have have cut its stake to between 5% and 10%, or even lower, while Lloyds would have to prove to be able to buy back its own stock at a fast pace, and at a decent price. 

At at time when the direction of interest rates is not a given, investors who hold long positions seem confident that the bank’s balance sheet and its income statement are strong enough to cope with toppy markets, volatility, hefty fines, fierce competition, high private debts and a zillion of other factors, without disappointing neither the City nor the retail side. 

In this context, I’d expect a more troubled path to dividend growth than many observers do.