Correction triggers City upgrade for Lloyds

Bearish sentiment has wiped off nearly 20% of Lloyds' market value over the last five weeks. But investors who buy shares in the banking group could be looking at a 12% total return over the next year, analysts at Investec reckon. Lloyds certainly isn't the broker's top pick in the banking sector, but with a tasty 2016 dividend yield of 6.8%, there are definite elements of interest.

"We have no intention of joining the growing ranks of analysts with a target price of 100p or more for Lloyds' shares," says analyst Ian Gordon "which is a level not seen since 2008. Although Lloyds is not our top pick, [the] correction in itself triggers an upgrade to 'buy'."

Plummeting from July highs of 88p to a low of 72p on Monday 24th August, Lloyds' market value had dropped 18% since mid-July. The shares had rallied to 77p on Tuesday, and Gordon still thinks the shares are worth 86p, reflecting an expected total return of 12%.

A sharp drop in impairments in the group's second quarter meant underlying pre-tax profit of £2.2 billion beat consensus estimates by 13% , with total operating income of £4.5 billion also beating expectations. However, the group logged a £1.4 billion charge for payment protection insurance (PPI) mis-selling and its CET1 ratio - a key measure of balance sheet strength - missed forecasts. Gordon reckons Lloyds' large PPI charge was a result of the group making the most of the final window for tax relief against provisions for redress payments.

Lloyds could return as much as £25 billion to shareholders over the next three years, after it announced plans to return surplus capital via special dividends or buy-backs last month. Investec reckons the shares are trading with a 6.8% dividend yield for 2017, with a return on equity of 11.6%.

"We think that Lloyds continues to prioritise 'margin preservation' over delivery of targeted balance sheet growth, but to be fair, the strategy has so far paid off," says Gordon. "Tactical brands offer further scope for liability repricing while we think Lloyds’ candid acknowledgement of limited net interest margin benefit from initial interest rate moves anticipates a vulnerability to increased mortgage back-book churn."

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The government continued the sale of its stake in the banking group yesterday, reducing its holding to 12.97%, a move Gordon "welcomes". Chancellor George Osborne wants to complete the process within a year, but it might not be so easy in current markets.

The Treasury was forced to halt yesterday's transaction after the shares dropped below the amount taxpayers paid to bail out the bank in 2008. This level may provide an element of technical support, says Gordon.

Investec prefers RBS and HSBC - its top pick in the sector is One Savings Bank.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.