UK Edition
Questor: ‘We do not expect any other FTSE 100 bank to make such returns in our lifetime’
Questor Income Portfolio: this is one analyst’s striking verdict on Lloyds Banking Group as its return to health continues
This column in its various guises often emphasises the importance of a business’s return on capital figure because of the simple truth that a company cannot make sustainable profits for shareholders if its return on capital fails to exceed its cost of capital (the interest rate it pays on its debts or the implied returns when investors decide at what price they are prepared to buy new shares).
In some cases it is more appropriate to look at return on equity than return on capital (the difference being that the latter includes any debt financing). And in the case of banks, the “return on tangible equity” is often used, with the purpose of excluding intangible items such as goodwill.
We explain this so that we can record a striking milestone expected to be reached soon by Lloyds Banking Group, which published a first-quarter trading statement last week. Its return on tangible equity was 11.7pc in 2018 and Ian Gordon, a banking analyst at Investec, the broker, whose bullishness about the bank’s return to health over recent years has been borne out by events, forecasts a figure of 14.6pc this year and the two following years.
“We do not believe that any other existing FTSE 100 bank will achieve a 14.6pc return on tangible equity in our lifetime,” Gordon said in a note last week.
This reassures us that, assuming we were right to include a big bank in the Income Portfolio, we chose the right one. We also like the simplicity and comprehensibility of Lloyds’ model: a focus on “retail” rather than investment banking in Britain alone.
The benefits of its approach are, we believe, now to be seen in its financial results. In addition to the strong returns on equity we can also see how the baleful impact of non‑standard costs such as PPI redress is dying away.
Such costs, which also include restructuring charges, fines from regulators, costs related to the demerger of TSB and amortisation, among other things, peaked at more than £6bn in 2014, Investec said. But they have been dwindling for some time.
- Read Questor’s rules of investment before you follow our tips
Last year, for example, they totalled £2.7bn and Gordon said he expected the figure to continue to fall to £1.2bn this year, then £1.1bn and £1bn in 2020 and 2021 respectively.
The other major drain on Lloyds’ profits since the financial crisis has been “impairments” or loans that have gone bad. These costs have also fallen dramatically, from a peak of about £25bn in 2009 to about £1bn now.
Between them, exceptional costs and impairments have driven the bank’s profitability. This is because, perhaps surprisingly, net income – broadly the difference between what Lloyds makes from interest on loans and what it pays on savings – has been relatively stable since 2008, while operating costs have been declining slowly but steadily.
Hence, as exceptionals and impairments have fallen rapidly, the bank’s profits before tax have risen significantly. Gordon expects a further large improvement this year to £7.5bn, followed by broadly similar figures in the next two years as impairments and exceptionals run out of room to improve further.
In another development last week, Lloyds said it would target a slightly lower level of capital reserves of 13.5pc of assets, down from 14pc. Its assets, in this case on a “risk-weighted” basis, totalled £206.4bn last year, so a reduction of half a percentage point is equivalent to about £1bn.
So Lloyds will end up with £1bn that it no longer needs to hold in reserve and could use to repurchase its own shares. Gordon said: “Other things being equal, there will be a £1bn (one-time) uplift in Lloyds’ 2020 share buy-back capacity. Wonderful news! The size of the buy back should be announced in February 2020.”
As we have reported before, the bank has already been buying back its own shares with surplus cash. It intends to spend £1.75bn on share repurchases this year, of which it has completed about £350m so far.
This money is on top of dividend payments and, while it does not end up directly in the pockets of investors who maintain their stakes, it does have the effect of increasing the profits attributable to each remaining share, which gives scope for dividend rises.
The shares remain a hold for the Income Portfolio.
Questor says: hold
Ticker: LLOY
Share price at close: 60.89p
For the best of the Telegraph's investment analysis, advice and expert opinion, sign up to our weekly newsletter.