Right now, Lloyds Banking Group (LSE: LLOY) looks cheap against conventional valuation measures. And part of that situation has been helped by the 30% plunge of the share price over the past five months or so. But it’s fair to say the bank looked cheap for a long while before that too.
So, should I buy some of the shares? After all, with the price close to 53p as I write, the forward-looking earnings multiple for 2020 is around seven and the anticipated dividend yield about 6.7%. On top of that, Lloyds trades at about 0.7 times its book value. It really is hard to make a case for the share looking expensive right now, but let me try…
Here’s why I think the valuation looks low
Over the past few years, I’ve read lots of suggestions about why the stock is languishing at these low levels. It’s all the misconduct issues such as the PPI scandal, cry some. Others think the Brexit situation hangs over the share, and so on. But although such issues will have their effect, I don’t believe Lloyds’ low valuation has much to do with any of that stuff.
My view is the Lloyds share price is being driven by investors’ perceptions of the inherent cyclicality in the banking industry. To me, banking is about as cyclical as cyclical businesses can be. Indeed, the share prices of banks such as Lloyds can be amazingly responsive to changes in the macroeconomic landscape or to investors’ expectations about the changing macroeconomic picture.
Well-known contrarian investor David Dreman once said banks tend to be the first in and the first out of recessions. Indeed, their share prices can cycle up and down and be a first-movers when it comes to expectations about the wider economy. But it’s not just their share prices that tend to cycle. Earnings, cash flow and dividends can cycle up and down over time too.
And that’s why I think Lloyds gives the impression of being cheap now. It makes sense for the stock market to price it low if it thinks earnings are at, or near, the top of their cycle. After all, if earnings were to fall by half from their current level, the valuation wouldn’t look so low.
But if earnings do fall, it could also lead to a dividend cut. And with all that going on in the storm of some future economic downturn, I can’t imagine the share price escaping unscathed, even though the market is trying to peg the valuation now.
Beware of the ‘square’ share
I see low valuations with banking shares as a warning, especially when they come on the back of a period of high-looking earnings. And that’s just the situation we are seeing with Lloyds today.
I’m nervous about its share price because there’s only the width of a fag paper’s distance between the figure for dividend yield and the figure for the earnings multiple.
I remember the last time Lloyds was hailed a ‘square’ share, back in 2007 – some investors piled in on valuation grounds, just in time for a 90%-plus plunge in the share price. I admit circumstances were extraordinary back then but, just in case, I’m avoiding the stock right now.