How Lloyds Bank stock can confound value investors

A brochure showing some of Lloyds Banking Group's major brands

Lloyds Banking Group (LSE: LLOY) deserves an award. I’d send it a medal for being the most consistently cheap-looking stock that rarely seems to go higher.

The valuation often looks low. It’s a big and well-known name. It often pays a chunky dividend. And it nearly always looks attractive — if I fall into the trap of thinking good value merely means cheap.

Cheap isn’t necessarily good value

But decades ago, ultra-successful investor Warren Buffett ditched the idea of cheap being good on its own. It’s true he started his investing career buying stocks that looked cheap on the numbers. Then he’d hold the shares of those often poor-quality businesses for one final puff. Just like we can get a final drag from somebody else’s discarded cigar butt – yuck!

Buffett played that game for a while but came a cropper when he bought failing textile mill company Berkshire Hathaway. No matter what he did, he couldn’t turn the business around. So, he ploughed the cash flow into other lines of business and stocks, closed down the original textile operations, and the rest is history.

The failure of the enterprise helped Buffett to move towards the investment style he uses today. And that means defining good value as quality businesses with decent prospects selling as cheaply as possible. But the cheap part of the process rarely means bargain-basement prices. Buffett often talks about paying “fair” prices for “wonderful” businesses.

And Lloyds is cheap on the numbers. There’s no doubt about that. With the share price in the ballpark of 45p or so, the price-to-tangible-asset value is around 0.8. And there’s that anticipated dividend yield above 5%.

The challenges of holding Lloyds Bank stock

But Lloyds falls down when it comes to quality indicators. And for me, one of the biggest quality red flags is the firm’s patchy trading and finance record. Looking at the past few years I can see that revenue, cash flow, earnings, dividends and the share price have all jumped up and down like a fiddler’s elbow.

And there’s a good reason for that – cyclicality. Of all cyclical sectors, I think banking is among the most sensitive to the ups and downs of the economy. But it’s not just actual movements in economic activity, it’s sentiment as well. If there’s even the slightest whiff in the air of a downturn coming, Lloyds and other banks will be among the first and most furious shares to react. And that often means plunging share prices.

Of course, that works on the upside as well. And Lloyds will likely move higher when sentiment improves and investors believe economic conditions will get better. But when that happens, the market is often cautious. And despite improving earnings, there’s often downwards pressure on the company’s valuation over time. Why? Because investors don’t know when the next cyclical downturn will arrive, but they know that it will at some point.

And that’s why I reckon Lloyds bank stock can confound value investors. It looks cheap when it’s trading well, but the valuation rarely re-rates higher. However, cyclical risks to the downside can remain elevated when business is booming.

Perhaps I’m wrong and Lloyds will soon take off to give shareholders a decent return. But I’m avoiding the stock when it comes to my long-term portfolio.

The post How Lloyds Bank stock can confound value investors appeared first on The Motley Fool UK.

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Kevin Godbold has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended Berkshire Hathaway (B shares). The Motley Fool UK has recommended Lloyds Banking Group and has recommended the following options: long January 2023 $200 calls on Berkshire Hathaway (B shares), short January 2023 $200 puts on Berkshire Hathaway (B shares), and short January 2023 $265 calls on Berkshire Hathaway (B shares). Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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