I can’t think of a riskier potential investment in the FTSE 100 than the ‘opportunity’ to invest in the big banks, such as Lloyds Banking Group (LON: LLOY).
With so many other sectors crammed with better businesses, why do private investors play financial Russian Roulette with the likes of Lloyds?
That’s a rhetorical question I can’t answer, but I can tell you some of the things that could go wrong with an investment in Lloyds now.
Lack of earnings visibility
It’s hard to predict how much or how little a big bank such as Lloyds might earn from their operations from one period to the next. With firms in other sectors, I can make a reasonable stab at predicting how things are going because their operations are easier to understand. The banks, however, with their high financial gearing and esoteric earnings streams, are like black boxes with no windows.
Think of all the scandals generated by the big banks in recent years for dodgy practices. Did you see them coming? Who knows what the banks get up to make a buck? I know Lloyds and the other banks are working towards cleaning up their operations, but I can’t see inside well enough to risk investing in the big banks.
Cyclicality
The banking industry is known for its cyclicality. When bank shares aren’t plunging down or shooting up they seem to mark time as their valuations compress, even though earnings might be rising year on year. The market tries in vain to smooth out the cyclicality in the industry, which means that it keeps valuations low as earnings rise.
When we see high dividend yields and low price-to-earnings (P/E) ratios, that’s the market looking for the next cyclical plunge in a bank’s earnings. Despite the stock market’s efforts to value banks modestly, it usually fails and a macroeconomic slowdown tends to cause banks’ shares to plunge a long way. After that, the big dipper starts again, and the outcome for long-term investors can be poor. Dividend gains give way to capital losses and vice versa and an investment in the big banks like Lloyds can go nowhere.
Right now, Lloyds shares have been flat for two years or so even as earnings rose, as the valuation compresses. There’s been a small downwards correction in the shares recently but at some point, a larger plunge in the share price and a collapse in earnings could happen. Why should I take the risk with the banks now?
Regulatory drag
Since last decade’s financial crisis, regulators have been bearing down on the big banks to try to make them more resilient to financial shock. That has led to higher requirements to hold capital reserves to strengthen the banks’ balance sheets and requirements to separate core banking operations from speculative investment operations. Banks are also paying huge fines for misdemeanours and dodgy money-making practices.
There’s little sign that the banks will avoid intense scrutiny in the future. One objective of the regulators seems to be to cut down the size of the big banks so that they can never threaten the stability of the world’s financial system again. With so strong a regulatory headwind, I think big banks such as Lloyds are best avoided altogether.