Why I'd sell Lloyds Banking Group plc to buy Prudential plc

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Lloyds

As its competitors still struggle with billions of pounds of bad assets on their books, low returns and even lower dividends, Lloyds Banking Group (LSE: LLOY) has quietly but surely turned itself into the healthiest bank in its peer group. But while Lloyds' 4.1% yielding dividend is nice, I'd much sooner invest in the more diversified, faster growing insurer Prudential (LSE: PRU).

The best of a bad lot 

The main reason I'd steer clear of Lloyds is that I see fairly limited potential for capital appreciation from owning its stock. My bearishness on this front comes from several sources, the first is that after rising a tad over 100% in value over the past five years its stock is looking fully valued to me at 1.07 times tangible book value.

Of course, if the value of its assets rose through expansion and profits growth, the share price would naturally rise. But the issue here is that there is fairly limited upside growth potential as Lloyds is already the dominant UK retail bank. It has little scope to appreciably increase its market share above the roughly 25% of both the current account and mortgage market it controls. The company is looking for other growth avenues, most recently wealth management, but this is already a very crowded sector that most other banks have already tapped.

Furthermore, with economic growth at home tepid at best, it'll be hard-pressed to rely on a booming economy to buoy its loan book. And while other big banks are finding cost-cutting a reliable way to boost profits, Lloyds has largely done the hard lifting already. In the half year to June it brought its cost-to-income ratio down to 45.8% and improved its underlying return on equity, which strips out PPI claims payments and other one-offs, to 16.6%. These are fantastic figures, but in this world of low interest rates and increased compliance costs from regulatory pressure, there's little scope for Lloyds to significantly increase profits without economic growth kicking up a notch.

In sum, Lloyds looks fully valued to me and while the bank has done well to turn itself into a lean domestic-oriented retail bank, its fairly low growth prospects more than outweigh its decent income potential in my eyes.

Growth galore 

On the other hand, Prudential has very enviable growth prospects due to its exposure to the highly profitable US market as well as the rapidly developing Asia Pacific region. In H1 these two regions more than made up for desultory 1% year-on-year (y/y) operating growth from UK businesses by boosting operating profits by 7% and 16% y/y respectively.

Over the long term, both of these markets offer considerably higher growth potential than Lloyds can tap into in the UK. In the US, Prudential is benefitting from the expanding pool of retirement age Americans needing annuities and other investments. In Asia it is the increasingly wealthy and numerous members of the middle class who need insurance, asset management and retirement solutions.

The potential of these two markets is so great that investors are taking seriously the idea of hiving off the low growth UK business to focus on them. Even if this doesn't come to pass, I'd choose Prudential over Lloyds due to the former's growth prospects, its decent 2.5% yield and attractive valuation of just 12.5 times forward earnings. 

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Ian Pierce has no position in any 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.