Beware the siren call of the Lloyds share price

Road sign warning of a risk ahead
Road sign warning of a risk ahead

I reckon an investment in Lloyds Banking Group (LSE: LLOY) is likely to deliver limited upside potential and significant downside risk due to the cyclicality of the firm's activities. The Lloyds share price has remained in a tight range for years and now the firm's valuation metrics look tempting. But can you afford the cost and risk of having Lloyds in your portfolio?

Busy going nowhere

Today's share price is close to the level it first achieved after the credit-crunch nadir in the summer of 2009. Over those nine years, we've seen it dip below 25p and flirt with 90p, but now it's back where it started. Meanwhile, the FTSE 100 index is around 80% higher. So in terms of capital gains, you'd have been better off holding a FTSE 100 index tracking fund than holding shares in Lloyds after what has been a significant underperformance from the banking stock. Investor income from the dividend has been dire too. There were no dividends until payments restarted during 2014. You would have collected 9.6p in dividend payments over the past nine years. Again, you'd have been better off collecting dividends from a FTSE 100 tracking fund, which today is yielding around 3%.

But Lloyds' low-looking single-digit forward price-to-earnings ratio, its modest price-to-book value and its fat forward dividend yield above 5% are combining to lure investors, just as the Sirens of Greek mythology lured sailors. Their enchanting music and singing voices drew seafarers to the rocky coast of those dangerous creatures' island where the sailors' ships would smash to pieces.

Cyclical to the core

Lloyds banking business is cyclical to its very core. To prosper, Lloyds need its personal and business customers to thrive and if they are hit by a downturn in the economy, Lloyds profits and cash flow will go down too. If that happens, the dividend could be trimmed and the share price could fall, perhaps as much as 50% or more. That situation is an ever-present danger for investors with out-and-out cyclical firms. Is it a risk you are prepared to take with a long-term approach to investing?

The market as a whole 'knows' about the risks Lloyds and other cyclical firms face and tends to keep their valuations low. As the up-leg of a macro-cycle unfolds, and as a cyclical firm's profits rise, the market tends to crimp valuations lower and lower in anticipation of the next downturn. Such valuation-compression can work as a real drag on share-price progress. If you hold a firm such as Lloyds, there's an opportunity cost because you could be in a better investment. Is that a cost you are prepared to bear?

Lloyds expects to pay a total dividend of 3.39p in 2018. Imagine that you decide to hold the stock for the next nine years and it pays an average annual dividend of, say, 5p. You'd collect 45p. However, if the share price remains close to 70p over that period, which is possible, it would only take a share price slide of 64% or so to wipe out almost a decade's worth of your gains. With so many better opportunities on the London stock market, I think avoiding Lloyds is the right thing for my long-term portfolio.

Getting Rich Slowly

It's easy to make a million by using a simple strategy such as tracking the FTSE 100 and letting your money work for you. Unfortunately, most investors 'over-trade' and, as a result, their returns suffer significantly...

To help you avoid this key mistake, the Motley Fool has put together this free report entitled "The Worst Mistakes Investors Make". These mistakes can cost you thousands over your investing career but the best part is, this report is free to download.

Click here to get your copy today.

Kevin Godbold 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.