Lloyds (LSE: LLOY) banking group issued its interim results yesterday. They contained some good news, including a large increase in the interim dividend. But I sold my Lloyds shares this week. Here is why.
Strong business, weakening environment
I initially invested in Lloyds because I liked the business model. Financial services benefits from durable demand – people will always need money. Lloyds has a collection of well-known brands including Halifax and Bank of Scotland. That gives it a very strong position in the market. Indeed, it is the country’s biggest mortgage lender.
That helps explain why it recorded after tax profits of £2.8bn for the first six months of the year. The company has a market capitalisation of £31bn, so on a price-to-ratio earnings basis I think that makes Lloyds shares look cheap.
But although the profits were strong, they were well below last year’s figure of £3.9bn for the same period. That performance partly benefited from some unusual items, such as releasing reserves that had been put aside until the impact of the pandemic on the bank’s finances was clearer.
But over recent months, I have been watching for signs of whether a worsening economic environment could push up customer defaults and hurt profits. I feel we are now seeing this risk get bigger, which is why I sold my shares.
The risk of higher defaults
The bank remained upbeat on this front, saying: “Observed credit performance remains robust and the flow of assets into arrears, defaults and write-offs remains at low levels.” That sounds reassuring.
But the company set aside £381m as an impairment charge to reflect the value of money or assets due to Lloyds that it does not expect to receive at their previous valuation. That compares to a release of £723m of charges at the same stage last year.
Again, that was unusual and reflected the economic uncertainties of the pandemic, which were then becoming clearer from the bank’s perspective. A £381m impairment charge is still below what we saw the 2019 interim results, before the pandemic. But it is sizeable all the same.
What concerns me is that we are now starting to see more impact from the stuttering economy. I think that could lead to bigger impairments in the second half and beyond. That cost might be offset by higher interest rates, which can help boost income for a mortgage lender like Lloyds.
But I still feel nervous about what an expected recession could mean for default rates and therefore profitability. Recessions can hurt bank earnings badly in a short timescale.
Why I sold my Lloyds shares
On top of that, the Lloyds dividend remains far below where it used to be. The interim dividend was around 20% higher than last year, at 0.8p per share. But that still leaves it 29% below where it was three years ago.
From an income perspective, I think Lloyds shares look decent. But I fear management’s reluctance simply to restore the former dividend is a concerning sign. If profits fall sharply, I can imagine the dividend being cut fast.
With an uncertain growth outlook and doubts about the long-term dividend outlook in a recession, I feel the current market offers me better opportunities elsewhere. So I sold my Lloyds shares.
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Christopher Ruane has no position in any of the shares mentioned. The Motley Fool UK has recommended Lloyds Banking Group. 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.