Lloyds Banking Group has more UK current account customers than any other bank and it provides more UK mortgages than any other lender, so when it comes to UK-focused banks, Lloyds is the 800lb gorilla.
It’s also one of the most popular shares with dividend investors, with more than two million shareholders.
Lloyds is also very old, having been established in 1765 when a Quaker by the name of Sampson Lloyd co-founded a small lending business in Birmingham.
Many dividend investors are looking to invest in large, long-established market leaders, and Lloyds certainly fits that bill.
But there are many different types of dividend investor, from those who are mostly interested in high dividend yields to those who are mostly looking for high dividend growth.
I'm somewhere in the middle as my primary goal is to own high-quality dividend growth stocks at a reasonable price, so I'll be looking at Lloyds through that particular lens.
The UK’s biggest provider of current accounts and mortgages
When most people in the UK think of Lloyds Bank, they think of black horses running across their TV screens in the company’s famous ads. They also know Lloyds is one of the UK’s biggest banks and a provider of current accounts, savings accounts, loans, mortgages and all of the good things that most mainstream banks provide.
And that is a pretty accurate picture of what the business does.
Most of Lloyds’ income is generated from millions of loans to individuals, most of those loans (by value) are mortgages and they’re mostly funded by customer deposits held in millions of current accounts and savings accounts.
To give you an idea of its size, the bank's residential mortgage book was valued at £311 billion in 2022, giving it a market-leading 17% share of the UK mortgage market.
In addition to mortgages, Lloyds extends credit in the form of overdrafts, credit cards, personal loans, motor finance and so on, all of which are standard products for a mainstream bank. All in all, lending to individuals makes up about 80% of the overall loan book.
The remaining 20% is made up of loans to small, medium and large businesses and, once again, this is pretty much standard fare for a mainstream bank.
Last and also probably least, Lloyds provides wealth management services, insurance and pensions to individuals. This is a relatively small and non-core part of the business, so I’m going to ignore it for now and focus on the core banking business instead.
I should also mention that thanks to some not-always-successful acquisitions, some parts of the Lloyds group provide their services under other brands, including Halifax, Bank of Scotland and Scottish Widows.
Sustainable growth has been largely absent since the financial crisis
As I've already mentioned, I’m looking to invest in quality dividend stocks, but only when the share price offers a decent combination of income and growth.
Quality dividend stocks have a proven track record of consistent and sustainable dividend growth, so that’s the first thing I look for.
Data source: SharePad
In Lloyds’ case, there has been strong dividend growth over the last ten years, but only because the bank wasn’t paying a dividend ten years ago. It wasn't paying a dividend because ten years ago, Lloyds was still very much in survival mode, having taken the financial equivalent of a bullet to the chest at point-blank range during the 2009 financial crisis.
It should have been a fatal wound, but Lloyds was kept alive when the government and shareholders pumped tens of billions of pounds into the business to strengthen its balance sheet. The share price was decimated and the dividend was suspended for five long years, but the bank survived and over the following years the dividend gradually recovered, albeit with a major dip in 2020 thanks to the pandemic.
That dividend growth has been supported by earnings growth, but once again, that growth simply reflects the bank’s recovery from negative earnings ten years ago.
Although it's good that the bank has recovered, recovery-driven growth isn't sustainable because a recovery is a one-off event, and that's a problem because I'm looking for sustainable dividend growth.
For a mainstream bank to produce sustainable growth, it needs to consistently grow three things in this order:
- Shareholder equity
- Customer deposits
- The loan book
Equity should be grown first because it’s the foundation upon which all companies are built. That’s especially true of banks because shareholder equity acts as a buffer to protect depositors by absorbing losses caused by bad loans.
For example, a simple bank might raise £100 million of funding through customer deposits and lend the whole lot out as car loans and home loans. If that bank has £10 million of shareholder equity, then up to 10% of its loans could default before the bank became insolvent and unable to repay all customer deposits. If the bank only has £1 million of equity then a mere 1% loan default rate could wipe the bank out and put its depositors at risk.
If a bank’s equity grows to where it’s more than sufficient, management can then focus on raising additional funding by increasing the total amount of customer deposits, but not by so much that the equity buffer becomes too thin.
Once a prudent amount of additional funding is available from increased customer deposits, it can be loaned to borrowers. The interest from those additional loans should drive higher profits, some of which can be retained to further increase shareholder equity, which can then support further deposit and loan expansion, and so on.
That’s the theory at least, so how has Lloyds performed over the last ten years in terms of growing its equity base, its customer deposits and its loan book?
The answer is, not very well.
Equity, deposits and loans have all remained broadly flat over the last ten years, so although Lloyds hasn’t gone backwards, it hasn’t gone forwards either. Unfortunately, thanks to the wonders of inflation, if you aren’t going forwards you’re actually going backwards, so I would consider this lack of growth a red flag, i.e. a serious warning that Lloyds may be lacking in the quality department.
To be fair, when the government became the largest shareholder during the financial crisis, Lloyds’ reason for existing changed significantly. Out went its previous high-risk, high-growth strategy and in came a new purpose of helping Britain prosper by becoming the best low-risk, low-cost UK bank.
That new purpose may be laudable, but at the end of the day, I want to see a long track record of sustainable inflation-beating growth and Lloyds doesn’t have one.
Profitability has at long last reached acceptable levels
Although sustainable dividend growth is important, it doesn’t tell you whether you’re looking at a quality business or not. History is, after all, littered with companies that grew rapidly for a decade or two before disappearing with a bang or a whimper.
The true measure of quality is an ability to consistently generate above-average returns on capital over many years, supported by profit margins that are, at the very least, not overly thin.
How does Lloyds measure up against those lofty standards?
Well, in 2021 and 2022, Lloyds produced net returns on capital of about 10%, which is above average and in line with what I would expect from a quality dividend stock.
Its net interest margin (effectively profit margin for banks) was also acceptable in 2022 at just over 3%.
However, although I’m pleased to see Lloyds posting more or less acceptable levels of profitability in 2021 and 2022, two years of acceptable profits is nowhere near enough to make Lloyds a quality company.
If we look further back towards the financial crisis, it becomes clear that Lloyds has spent most of the last ten years producing unequivocally weak returns on capital.
Given that Lloyds was still loss-making ten years ago, its returns on capital in 2013 were obviously negative. Those returns became positive in 2014, but they were exceptionally weak at just 2%. Returns on capital then slowly recovered to double-digits by 2021, but that still leaves the bank's average net return on capital at a very unimpressive 5% for the period as a whole.
More importantly, its net return on capital only exceeded the 7% UK average in three of the last ten years.
This weak performance is understandable because Lloyds was in intensive care for much of the early 2010s. In fact, the situation was so bad that the company's CEO had to take extended sick leave as a result of stress-induced insomnia.
If I wanted to build a world-class bank then, as wise people have said throughout the ages, “I wouldn’t start from here”, but that is where Lloyds started and, as a result, its track record of weak returns is understandable.
But understanding something doesn’t mean you have to accept it.
The simple truth is that Lloyds only managed to produce acceptable net returns on capital three times in the last ten years and that is not what I’d expect from a quality dividend stock.
At this point, I think I’m going to pull the plug on Lloyds because it has failed to pass my two most basic rules of thumb:
- Rule of thumb: Only invest if the company has produced sustainable and inflation-beating dividend growth over the last ten years
- Rule of thumb: Only invest if the company has consistently produced above-average net returns on capital over the last ten years
In summary then, Lloyds may be the UK’s largest bank in terms of customers and mortgages and it may be one of the most popular stocks with dividend investors, but for the last ten years, it hasn’t produced sustainable inflation-beating growth and it hasn’t produced consistently strong returns on capital, so it doesn’t fit my definition of a high-quality company.
And as I don't think it's a high-quality company, I won’t be adding it to the UK Dividend Stocks Portfolio.
Lloyds is a mediocre bank, but it will still probably outlive all of us
To be honest, I’m not entirely surprised that Lloyds has failed to meet my standards for quality. Neither did HSBC when I reviewed it recently (Is HSBC a good choice for dividend investors?) and I would be surprised if any mainstream UK bank did.
The major banks are, in most cases, fairly mediocre businesses, but they benefit from powerful competitive advantages that help them survive for generations.
Their first advantage is that banking is all about trust. Most people have all of their income paid into their current account and many people have all of their life savings in a savings account, often at the same bank, so most people need to have a very high degree of trust in their bank.
Humans are social animals, so we trust what our peers trust, and that means most people bank with the same banks as everybody else, which is why the market is dominated by a handful of very large and mostly very old banks.
In addition, children often bank with the same bank as their parents because their parents are the ones who set up the account. By the time children become adults, 40% of them are still using the same bank account their parents set up decades before.
And so, with little or no effort, Lloyds and the other major banks get a steady supply of new customers with each passing generation, and those new customers often stay as customers for decades.
In fact, the average person stays with their bank for 17 years, which is longer than the average marriage. This tendency for people to stay with the same bank for decades, and often their whole lives, is the second key advantage that banks have over most other companies.
It’s hard to overstate how important an advantage those sticky customers are. Can you imagine being a retailer and knowing that as soon as someone buys so much as a sock from your store, they’re very likely to still be a regular customer 17 years later?
Retailers almost never get close to that degree of customer loyalty, but for banks, it’s easy because switching from one bank to another is a massive pain in the backside, or at least that’s what most people think.
However, it isn’t all sunshine and rainbows. If it was, Lloyds would be generating strong double-digit returns on capital year in and year out, but it doesn’t, and that’s because banking is mostly a commodity business.
In other words, a current account from one well-known big bank is much the same as a current account from another well-known big bank, and the same goes for savings accounts, personal loans, mortgages and so on.
The only real differentiator is price, so it’s almost impossible for one bank to consistently offer lower interest rates to savers or charge higher interest rates to borrowers without becoming uncompetitive.
This is why we have a small group of large well-known banks that have been around in many cases for centuries, but at the same time, those dominant market leaders are unable to consistently and sustainably generate attractive returns because none of them has a material advantage over any of their peers.
However, while the big banks are, by and large, a fairly unappealing bunch from a quality investor's point of view, it is possible to find high-quality banks if you’re willing to look beyond the big-name high-street contenders.
Currently, my UK Dividend Stocks Portfolio has one holding that operates in the banking sector, but it’s a specialist bank with a very different business model to mortgage-focused banks like Lloyds.
It's almost Christmas so I'm winding down my writing for 2023, but I'm hoping to publish a review of that bank in early 2024, just to prove that I'm not completely against the idea of investing in banks.
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